Minute By Minute

The FOMC June minutes were released this past week, along with the Committee’s most recent predictions as detailed in its Summary of Economic Projections (SEPs).

Although the press gave attention to the Committee’s views on the implications that the tariffs soon to be implemented might have for growth, in reality the minutes devoted only a couple of sentences to concerns that district contacts had about tariffs. Specifically, “… many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy.” Potential impacts on steel, aluminum, and agricultural prices and exports were noted.

While the minutes were largely unremarkable overall, there were a couple of points of emphasis that were different and potentially interesting. For example, the manager of the Open Market Desk pointed out that paydowns and maturing MBS were likely to fall short of the caps that had been established (the max for MBS being $20 billion per month), indicating that reinvestment in MBS was likely to be unnecessary and implying that shrinkage of the MBS segment of the System Open Market Account portfolio would be less than planned. Indeed, as of the end of June, the shrinkage of the aggregate portfolio was about $22 billion short of target, and at the present pace the shortfall will be much greater by the end of July.  Having said that, paydowns could, depending upon what happens to rates, again exceed the target reductions in MBS. So as a contingency, the Desk staff proposed continuing to make small MBS purchases to maintain operational readiness should redemptions exceed the targets and purchases again become necessary.

Additionally, the Committee appeared to have spent considerable time discussing the strength of labor markets and the implications that had for potential wage increases. As for risks, the Committee again noted policy uncertainty, especially with respect to trade policy and the negative implications for investment and business sentiment.

The most interesting discussion, however, in the entire set of minutes was the attention that was paid to the flattening of the yield curve and what, if any, signal that trend may have as a harbinger of a future recession. Several factors in addition to the tightening of policy were seen as possible contributors, including a reduction in the longer-run equilibrium rate of interest, lower inflation expectations, and a lower term premium, in part related to central bank asset purchases. Views appeared to be mixed and relatively split between those who felt that the above factors reduce the meaningfulness of a flattened term structure as an indicator of recession probabilities and those who felt that the flattening curve is still a useful indicator. Staff apparently presented research looking at the usefulness of measures of the spread between the current and expected federal funds rate derived from futures markets as predictors of recessions. In general, the System has continually devoted attention to yield-curve inversions as predictors of recessions, and the general conclusion is that a negative yield curve has led all but one recession since 1955, with a lag of between 6 and 24 months.[1] Bauer and Mertens’ most recent work shows two key things. First, while inversions may signal an increase in the probability of a recession, at the critical threshold of a zero spread, the probability of a recession 12 months ahead is still only 24%.[2] They also note that as of February 2018 the estimated probability based upon the spread that existed at that time was still only 11%, which they viewed as “… comfortably below the critical threshold….”

As for the risks to the economy associated with the potential trade war initiated by the US, it is interesting to look at statistics on US and China trade relative to the size of their respective economies. Current estimates suggest that China’s GDP is about $12.2 trillion, while that of the US is about $19.4 trillion.[3] Of that, US exports of $1.4 trillion are about 7% of US GDP, and imports of $2.4 trillion are about 12.4% of US GDP. Trade is much more important to China than it is to the US. Chinese exports are 17.2% of GDP, and imports (which historically have consisted of raw materials and intermediate inputs to their exports) are about 15.6% of GDP.

US trade with China, especially the deficit, has gotten a lot of attention. However, US exports to China are less than 1% of US GDP, and imports are about 2.5% of GDP. As of this writing, the administration has imposed tariffs on about $35 billion of US China imports, or about 0.2% of US GDP. While these appear to be small numbers, the impacts on certain US industries in many parts of the country, such as soybean farmers in the Midwest, are critically important to their well-being. Unfortunately, what the present approach to trade implies is picking winners and losers who bear the brunt of attempts to rationalize international trade policies, but is based upon the faulty logic that the US must have bi-lateral trade balances  with each of our trading partners.[4]  The political fallout from the coming trade war will be significant, but the immediate worry is not the overall economic impact, which by most measures is small.  Rather the more significant effects will be the impacts that tariffs may have on market psychology and business investment attitudes and decision-making. The emotional impacts may drown the real economic impacts.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] As but a small snapshot see: Bauer, Michael D., and Glenn D. Rudebusch. 2016. “Why Are Long-Term Interest Rates So Low?” FRBSF Economic Letter 2016-36 (December 5); Berge, Travis J., and Oscar Jorda. 2011. “Evaluating the Classification of Economic Activity into Recessions and Expansions.” American Economic Journal: Macroeconomics 3(2), pp. 246–277; Estrella, Arturo, and Frederic S. Mishkin. 1997. “The Predictive Power of the Term Structure of Interest Rates in Europe and the United States: Implications for the European Central Bank.” European Economic Review 41(7), pp. 1,375–1,401; Mertens, Thomas, Patrick Shultz, and Michael Tubbs. 2018. “Valuation Ratios for Households and Businesses.” FRBSF Economic Letter 2018-01 (January 8); and Rudebusch, Glenn D., and John C. Williams. 2009. “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve.” Journal of Business and Economic Statistics 27(4), pp. 492–503.
[2] See Bauer, Michael D. and Thomas Mertens, “Economic Forecasts with the Yield Curve,” FRBSF Economic Letter, March 5, 2018. https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/
[3] https://tradingeconomics.com/china/gdp; https://tradingeconomics.com/united-states/gdp
[4] Alan Blinder has a useful discussion of what we know about trade balances in WSJ July 9, 2018.

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Bursting Bitcoin Bubble?

Fundstrat Daily reports that “YTD, the crypto market is down -60.7%” as of July 2.

We have been asked again about Bitcoin and “bubbles” following the recent gyrations and the plunge. “Should I buy it?” asked a reader.


First, we offer the required disclosure: We don’t own any cryptocurrency in any Cumberland managed account. And we don’t own any derivative or other form of crypto. We have avoided the group. We don’t see crypto as a deep-enough and mature-enough assemblage of tokens to qualify as an asset class – yet. That assessment may change at some point but not likely soon.

Nick Colas and Jessica Rabe have been tracking Bitcoin for a while. They write about it from time to time. See http://datatrekresearch.com.

“We’ve been tracking Bitcoin wallet growth and Google search term volumes… as the carnage has unfolded. Our repeated message in these pages: the former is growing only slowly, and the latter is in outright decline. Bitcoin is ultimately a technology, and without incremental adoption growth it has a tough row to hoe.”

Later in their research they add the following warning: “To be clear: we’re not calling a bottom on Bitcoin, but its complete decoupling from stocks may be one sign of a washout [s]ince it now resembles the time before anyone but computer nerds really cared about it.”

Thank you, Datatrek, for keeping us up to date.

Readers may recall that in previous writings we argued that the world wants the use of crypto and security of blockchain linkage in a secret transaction. Illegal use is one reason. Privacy is another. So is having a wealth-hoarding mechanism that cannot be confiscated if the owner has to flee. As Fundstrat Daily noted (on July 2), “When comparing Bitcoin to other major asset classes (stocks, bonds, hedge funds, oil and gold), Bitcoin has the highest correlation to Gold (4.4%) and the lowest correlation to S&P 500 (-15.2%).”

We also see the eventual rollout of credible asset-backed crypto as an evolution in progress. Many gold-backed tokens are in the works or are in the start-up phase of issuance. That activity is mostly outside the US. We think it will expand and will intensify once the Venezuelan selling of gold has run its course. For more information about gold-backed crypto, see Goldscape’s weekly blog and guide at http://www.goldscape.net.

Note that Russia and China are continuously buying gold, according to official reports. Also note that a Sharia-approved, gold-backed crypto called OneGram (https://onegram.org/whitepaper) has launched in the Arab world. (This link is provided so readers can see this evolutionary development in crypto. It is not an endorsement.)

In sum, crypto is not over, though the Bitcoin bubble, having burst, may yet have more deflating to do.

The bursting of bubbles has a long history in finance and economics. That means the making of those bubbles is equally long in history. For a great recitation of bubble history see Charles MacKay’s famous classic, Extraordinary Popular Delusions and the Madness of Crowds (https://www.amazon.com/Extraordinary-Popular-Delusions-Madness-Crowds/dp/1539849589/ or find the PDF online.)

Commodities have bubbles. Silver, gold, copper and oil are examples.

Real estate has bubbles – housing, shopping centers, offices, the Florida land boom a century ago. The Florida condo boom today may become a future bubble.

Stock market bubbles are renowned –  bowling alley stocks, casinos, tech stocks, home builders, banks, savings and loans. From tulips to Trump’s Taj Mahal, the history of bubbles is littered with casualties.

Could FAANMG be the current stock market bubble? Is the hotel, leisure, cruise ship sector about to become a bubble, too?

Note that the bursting of a bubble doesn’t mean the selloff goes to zero. When the Nasdaq bubble burst 18 years ago, the Nasdaq lost two thirds of its value from peak to trough, but it didn’t go to zero. Some of the start-up companies that traded at price/fantasy ratios went to zero. Similarly, some start-up crypto ventures are now at zero.

In the end, markets clear to reasonable values, and the range of those reasonable values includes zero if the value is worthless.

Some have argued that Bitcoin’s rise was tied to stock market success and that the cryptocurrency’s subsequent decline portends a stock market crash. We’re not so sure of that linkage. We agree with the Datatrek conclusion: Despite occasionally looking like a barometer for systematic risk appetite, there continues to be no proof that Bitcoin’s price presages where the S&P 500 may go in the near term.”

We’re a lot more worried about the consequences of a trade war than we are about Bitcoin. We think the US economy is peaking in growth rate in Q2. The Trump-Navarro policy and an escalating trade war are already starting to bite. Ask Harley-Davidson. Ask a soybean farmer. Ask a Maine lobsterman. This is only the beginning.

We have some cash reserve. We took a defensive position in consumer staples. We favor small and midcap and domestic US versus international. We sold the overweight tech exposure.

David R. Kotok
Chairman & Chief Investment Officer
Email | Bio


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Tactical Trend, Q2 2018: “Embrace the Grind”

Sideways consolidating markets can test traders’ emotions. It is always a challenge to avoid overreacting to headline news and daily market gyrations. The broad US market as represented by the S&P 500 traded in a sideways range for most of Q2 as capital continued to rotate among both market cap and sectors.

Breadth has been positive, with small- and mid-cap continuing to outpace the broad index as capital looks to anchor to pure-play domestic vs. multinationals. Tech and health care, particularly biotech, are current market leaders and have been positive contributors to performance. These securities show strong relative strength in our analysis and are represented in the portfolio through our allocations to QQQ, XBI, and IBB.

June was a tough month for international markets as there were few places to hide. Both developed markets and emerging markets have been smacked hard and have pulled back off their strong 2017 runs. Even market leaders such as Japan (SCJ) and Hong Kong (EWH) have dropped sharply. Have the tariff and trade headlines put an end to capital flow to foreign equity markets, or is what we are seeing just a pause off the 2016 bottoms in both DM and EM? We are currently handicapping the decline as a nasty pullback, but market action will always trump opinion. We dipped into European Financials (EUFN) in late June as the sector appears to have created opportunity during its recent decline. Time will tell.

Please review our strategy allocations below but realize that positions can and will change as risk levels change.

US Equity: (60%) Broad market exposure through QQQ & RSP. We would look to add to our small-cap growth (IJT) position on any further weakness.

International Equity: (25%) 50/50 exposure to developed vs. emerging with a tilt towards Asia.

Fixed Income (0%): No position currently. Muni spreads vs. taxable appear attractive.

Commodities (0%): No position currently.

Cash (15%): Comfortable with this level.

Matthew C. McAleer
Executive Vice President and Director of Equity Strategies
Email | Bio


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Fed & Rates

My colleague Bob Eisenbeis recently described the improved communications from the Fed and offered his current thoughts on Fed policy. His post-Fed-meeting notes are here: http://www.cumber.com/the-fed-decides/.

Today we want to take a longer view of interest rates and offer some observations on what lies ahead. I write this after the FOMC June meeting and after I was fortunate to participate in a panel at the Benchmark Rates Forum New York 2018. That June 7th meeting brought together major players from around the world for sequential presentations about the coming changes in short-term interest rates and about the replacement for LIBOR. I thank Alexandre Ripley for inviting me to speak at this prestigious gathering. And I also thank KPMG, Bloomberg, and Latham & Watkins for sponsoring the day-long event.

Market Commentary - Cumberland Advisors - Interest Rates

One major forecast of shorter-term interest rates has suggested what rates will be in December 2019. The year-and-a-half time frame is not so long, but that forecast required considerable effort to develop a rationale behind each item. Let me extract and comment on what is a substantial, 60-plus-page document.

The forecast projects the upper end of the fed funds band to be 3.50% by December 2019. Remember that the fed funds rate-setting mechanism now operates with a high/low band for the FOMC target. The forecast calls for the lower end of the band to be 3.25%, which is also the expected RRP rate. This is the rate that is thought to reflect the use of repo, which is an alternative form of short-term interest rate cash management for those institutions that may not have direct access to the Federal Reserve. So the forecast target range is 3.25% to 3.50% at the end of 2019.

Interest that the Fed will pay on excess reserve deposits (IOER) is projected at 3.45%. This is 5 basis points lower than the upper band and is the extension of a new Fed policy that was announced at the June meeting. The Fed is trying to keep the fed funds rate within the targeted band. It faced a problem in that the FF rate was pushing against the upper end of the band for a variety of reasons. So the Fed raised the band by 25 basis points but raised the IOER rate by only 20 basis points. The 2019 forecast sees that policy decision continuing for the next year and a half.

The forecaster then estimated the rest of the short-term interest rates as follows. Treasury bills and related collateral would trade at 3.40%. SOFR (secured overnight funding rate) would trade at 3.35%. That would put 1-month LIBOR at 3.60% and 3-month LIBOR at 3.75%. The spread between LIBOR and the overnight indexed swap (OIS) is expected to be 30 basis points, and this estimate assumes that no shocks or credit problems rock the banking system and that LIBOR is fully functional.

Let’s think about what interest rates in the marketplace would look like if this forecast turns out to be correct.

As an investor, your cash equivalent options should be somewhere in the neighborhood of 3% or slightly lower. That is a major change from the last 10 years. We believe that is a rate high enough to change investor behavior and to restore the holding of some cash reserves by those investors who have been seeking to do so.

What can we expect for intermediate and longer-term rates if this forecast is correct? Here is where things get really difficult.

If the short-term and overnight SOFR is yielding 3.35%, is it reasonable to expect the intermediate and longer-term riskless US Treasury note and bond to yield less. That would mean an inverted yield curve, and that outcome is hard to see if there is a growing US economy. If there is a recession, it is hard to see how the Fed would have raised rates high enough to meet the forecast expectations.

So either we have to disagree with this forecast, or we have to raise the expectation for the 10-year Treasury yield to reach somewhere around 4%. We can quickly see what that figure does to mortgage interest rates and corporate bond rates and also to municipal bonds rates, although they are not likely to respond as much as corporate rates will.

Other forces are also at work and will influence the Fed. What happens to the unemployment rate over the next year and a half, and what happens to the inflation rate? The former is headed lower to about 3.5%, while the latter is headed higher. Are they on a collision course?

And lastly, what will be the impact when the European Central Bank starts to move away from its negative-rate targets and tapers its bond-buying program? And let’s not ignore the expanding US federal deficit and the Fed’s policy of shrinking the size of its asset holdings by allowing maturity and not replacing federally backed debt instruments. There is also the nascent trend of the Social Security Trust Fund’s rolling over, which means a transfer to the market to absorb the change. It isn’t much now, but it will be a growing force over time if the Congress doesn’t remedy the Social Security funding formula. Since Congress is usually reactive and requires a crisis to act, we are not sanguine about an early fix to Social Security.

Cumberland now uses a barbell strategy in its actively managed bond accounts. It does so for a very important reason. The strategy allows bond management to proceed when there are headwinds facing the bond market. Barbells are called for now. Ladders are likely to underperform. That is true for both taxable and tax-free bond accounts. And credit quality surveillance is a critical and ongoing need.

The next two years are going to be interesting and challenging.

We wish all our US readers a Happy July 4th celebration.

David R. Kotok
Chairman & Chief Investment Officer
Email | Bio


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SCOTUS – Two Major Rulings with Positive Implications for Municipal Bond Credit Quality

The Supreme Court of the United States (SCOTUS) on June 27th ruled in a 5–4 vote that government workers who choose not to join unions may not be required to help pay for collective bargaining and other union endeavors. Bloomberg estimates that this ruling will affect 5 million workers. Many feel that governments have been at a disadvantage, noting the conflict of interest that may arise when politicians must negotiate with the constituents that elect them.

Cumberland Advisors - Major Rulings with Positive Implications for Municipal Bond Credit Quality

Fewer dollars flowing into the political operations of organized labor may give governments a better negotiating position regarding municipal employee salaries and the pension and other postemployment benefits that are becoming outsized burdens on governments and taxpayers. Later in this commentary we compare right-to-work states (where employees cannot be required to pay agency fees to a union) and their pension funding status with the 22 non-right-to-work states. The upshot: 76.1% funded compared with 59.3% funded, respectively.

On June 21, 2018, the SCOTUS also ruled 5–4 to allow taxation of internet-based sales by ruling against the physical presence rule in the case of South Dakota vs. Wayfair. This ruling overturned past rulings that were predicated on an economy that did not depend on internet commerce; the historic Quill case was based on catalog sales. We think this ruling will benefit states and localities that have sales tax as a major revenue component and increase debt-service coverage on bonds that are secured by sales taxes. The change in sales tax collection may encourage more businesses to have a local presence because they would no longer be at such a competitive disadvantage with online retailers. Such a trend would further local employment and grow the local tax base.

We think these SCOTUS rulings are favorable for municipal credit, as discussed in further detail in our comments below and as mentioned in John Mousseau’s recent commentary “Tax Free Munis Continue to Perform”:  http://www.cumber.com/tax-free-munis-continue-to-perform/.

Pension Negotiations and Agency Fees

The SCOTUS ruling for the plaintiff in Janus vs. American Federation of State, County and Municipal Employees Council 31 eliminates the requirement that non-union public sector employees pay agency fees to contribute to the cost of collective bargaining and other activities through fair-share agreements. The court determined that requiring employees to pay the fees violates their First Amendment rights. The new ruling reverses a 40-year-old ruling that allowed the practice.

The Illinois Economic Policy Institute estimates the decision could decrease public sector unionization in California, New York, and Illinois by 189,000, 136,000, and 49,000, respectively. Vikram Rai and his team at Citibank think the drop could be even greater, citing the experience of Wisconsin. That state instituted union reforms in 2011 and became a right-to-work state in 2015. Since 2011, union membership in the state fell from 13% in 2011 to 8.3% in 2018.

An article in The Atlantic on June 27th, quotes from the court’s majority opinion, written by Justice Alito: “We recognize that the loss of payments from non-members may cause unions to experience unpleasant transition costs in the short term, and may require unions to make adjustments in order to attract and retain members.” The Atlantic further reports that some unions without fair-share agreements have stepped up to provide important services and more communication with their constituents in an effort to increase union enrollment.

The ruling is expected to bring more power to states when they are negotiating compensation and benefits with unions. Some states have already been able to gain concessions from unions regarding, for example, cost-of-living adjustments (COLA), which can have the biggest bang for the buck in reducing pension liability growth. States may have been making strides ahead of the ruling, possibly because unions are realizing the growing burden. Loop Capital Markets notes in a recent study that the gap between pension assets and liabilities shows no sign of narrowing, despite pension reforms, and that among states reporting 2017 data, the net pension liability has increased from $284 billion to $379 billion from 2014 to 2017, a period of generally favorable investment returns.

Moody’s recently maintained its stable outlook on Kentucky’s Aa3 with a stable outlook in part because of the credit benefits of recently enacted pension reforms that maintain employer contributions, reduce employee benefits, and create a new mandatory hybrid plan for teachers. Colorado’s outlook was revised on June 7th to stable from negative by S&P, following the state’s adoption of pension reform that should stem the decline in the funded level and lead to full funding in 30 years. In May, the Rhode Island Supreme Court reaffirmed a 2015 pension overhaul settlement that eliminated COLA adjustments, increased retirement ages, and formed hybrid pensions.

Fitch Ratings notes that regardless of the legal framework of a state, state and local governments remain limited in their ability to control labor spending and points to the mass demonstrations by public school teachers in several states. We commented on this phenomenon in our Q1 muni credit piece (http://www.cumber.com/q1-2018-municipal-credit/). Fitch does note that any changes arising from the ruling are likely to be incremental. We think that while some municipalities with large unfunded liabilities need immediate changes, pensions are a long-term issue, and incremental change can help.

The ruling will, it is hoped, reduce the politics of union negotiations and focus on the well-being of retirees, current employees, and taxpayers to arrive at sustainable solutions. This trend would bode well for municipal credit quality.

Right to Work and Pension Funded Level

A right-to-work state has laws that guarantee that no person can be compelled, as a condition of employment, to join (or not to join) or to pay dues to a labor union. The ruling essentially eliminates the right-to-work distinction going forward. However, comparing the pension funding level of the 27 right-to-work states with the others shows that right-to-work states enjoy better pension funding levels. The average funded levels for all states, according to Pew Trust, is 65.9%, while the funded status for right-to-work states is 76.1%, compared with 59.3% for the other states. The chart below shows the funded levels for all states. Not that there aren’t outliers, such as New York, which has a very well-funded pension and is not a right-to-work state, and Kentucky, which is a right-to-work state and has the second lowest funded status.

Pension Funded Ratios: 28 Right-to -Work States Compared with the 22 Non- Right-to-Work States

 

Sources:*National Conference of State Legislatures ** Pew Charitable Trusts

Sales Tax Ruling

As I noted earlier, the South Dakota vs. Wayfair Inc. ruling decided on June 21st found that a business did not need to have a physical presence in a state in order for the state to levy a sales tax. The decision also recognized improvements in technology that have changed the interpretation of previous rulings. We think this ruling will benefit states and localities that have sales tax as a major revenue component, improve debt-service coverage of sales tax-secured bonds, and may encourage more local businesses to have a physical presence, which would add to tax-base growth.

The effect could be muted in some areas, as some states had workarounds to address the issue, and major providers such as Amazon were already charging and remitting sales taxes. Amazon accounts for over 40% of online retail sales and already remits sales taxes to all states imposing them. However Amazon does not currently collect sales tax for most third-party sales, which represent about half of its total sales. The court noted in its decision that states should refrain from placing undue burdens on sellers to comply. Improvements in programs and services for smaller online sales companies will help to reduce the burden on the smaller firms to comply with the new law. There are already 20 states that participate in the Streamlined Sales and Use Tax Agreement, which establishes that out-of-state sellers can use tax administration software paid for by the state and are not liable for any mistakes made by the software.

According to a June 21st S&P release, the ruling will help stem state tax erosion in a changing economic environment. In 2017, e-commerce grew 15.9%, while retail sales without e-commerce grew only 3.4%, continuing a long-term trend. We expect most states that impose retail sales tax to enact new legislation that require at least large out-of-state online retailers to collect sales tax at time of sale. This legislation should provide a welcome incremental addition to state coffers. S&P also notes that this process may take some time.

All in all, the sales tax ruling creates a more level playing field and is positive for municipal credit quality.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


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Second Quarter 2018 Taxable Bond Market

The second quarter of 2018 saw a continuation of themes apparent in the first quarter. In June the Federal Reserve continued raising rates to a federal funds rate target that now stands at 1.75%–2.00%.

Market-Commentary-Second-Quarter-2018-Taxable-Bond-Market-with-John-Mousseau-&-Daniel-Himelberger

The flattening of the yield curve can be seen in the graph and table below. The 2-year, 10-year, and 30-year US Treasury bond rates continued to increase but at a pace that was measurably slower than in the first quarter.

 

*Data as of 6/26/18  Source: Bloomberg

 


The 2-year note rose the most in the second quarter, followed by the 10-year, with minimal movement in the 30-year Treasury. Thus the Treasury yield curve continues to flatten. Conventional wisdom holds that yield curves become flat in front of a recession, and those who embrace this notion now worry whether yield curve flattening may in fact signal an imminent recession. For now we disagree with that prognosis, for the following reasons:

  1.  (1) The yield curve is flattening, but it is not totally flat yet. In contrast, by the time the Federal Reserve was done hiking in the last cycle of 2004 to 2006, the yield curve looked like this.

 Source: Bloomberg

At that point in time the fed funds rate was slightly higher than the 30-year bond. Contrast that to the situation today, where there is still a 100-basis-point difference between the two.

  1. (2) Long Treasury yields are seeing plenty of demand because they are cheap relative to the rest of the world.

Here’s a recent comparison of US 2-year and 10-year bond yields to those of  other G-7 countries.


Source: Bloomberg


The US yield advantage ranges from 70 basis points to 330 basis points in the  2-year note and (if you exclude Italy at 3 basis points) from 80 to 292 basis points on the 10-year note. It’s hard to argue with the large advantage that US  bond yields offer compared to bond yields in the financially healthy G7 countries and particularly the less healthy ones. As long as the European Central Bank and the Bank of Japan are still in easing mode, the US government bond market should look good to global investors seeking sovereign debt. Call it an over-  demand for longer Treasuries if you will, but global investors have viewed the  US market as a bargain and kept downward pressure on yields.

  1. (3) Inflation has remained low relative to unemployment and relative to where the  Fed thought inflation might be.

Source: Bloomberg

Inflation has remained low – even with the low unemployment rate. Core inflation is lower now than late in 2015 and in 2016. Phillips curve enthusiasts have been frustrated, since the traditional tradeoff is that higher inflation accompanies lower unemployment. Certainly, inflation has stayed low for a number of reasons, including a stronger dollar, as well as the “Amazon effect,” which posits that it is very hard for manufacturers in any and all sectors to move prices meaningfully higher without drastic competition.

But another factor is also at work, and that is the real unemployment rate (U-6), which encompasses workers beyond the standard (U-3) measurement of unemployment. This measure includes people who are not working but not currently looking for work, people who have jobs but are looking for better jobs (think of someone downsized in the recession who now has a job but not at the level they had pre-recession), and people who are working part-time – some because they wish to work part-time and others because they can’t obtain full-time work.


Source: St. Louis Fed

In this graph we see the difference between the narrow measure of unemployment, U3, and the broader measure, U6. The gap – huge at the peak of the recession – has narrowed, but it is still larger than the gap that existed pre-recession. This gap is why the Federal Reserve has undertaken a more patient, slower pace of rate hikes than previous Feds: We think today’s Fed members are sensitive to the broader measures of unemployment, which until recently have been stubbornly high. And the gap is also one of the reasons that inflation has been slow to rise – particularly in the area of wages. The economy needs to lower this gap before wage inflation starts to work its way into higher inflation rates in the general economy.

Finally we have started to see some higher yield spreads on corporate bonds.

Corporate Bond Spread to 10-year Treasury

 Source: Bloomberg

We think some of this is reversion to the mean after two years of narrowing corporate bond yield spreads. But the trend may reflect some of the same jitters caused in the equity markets by the tariff tantrums. We feel this way because the yield ratios on municipal bonds have been narrowing. Part of that narrowing is supply-driven, but the difference between the two is another piece of evidence that the muni credit has dominant powers in many cases (think water, sewer, and transportation) and is not subject to the same profit jitters that affect corporations.

We wish all our readers a happy and healthy Independence Day.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Daniel Himelberger
Portfolio Manager & Fixed Income Analyst
Email | Bio


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Difficult Quarter for Eurozone Stocks

Eurozone equity markets have encountered significant headwinds in the second quarter of this year despite continued robust economic growth above estimated potential for most Eurozone economies.

Cumberland Advisors - Difficult Quarter for Eurozone Stocks

The continued strength of the Eurozone economies is emphasized in this month’s “OECD Economic Surveys: Euro Area.”[i] These economies have been growing since 2014. “GDP growth is expected to slow somewhat, but to remain strong by the standards of recent years,” the survey states. OECD projects Eurozone GDP to grow by 2.2% this year and 2.1% in 2019, compared with 2.5% in 2017. Factors driving this growth are the continuing expansion of the global economy, a very accommodative monetary policy, and a mildly expansionary fiscal policy. Among the reforms cited by the OECD that are needed to strengthen the resilience of these economies are a rapid resolution of the continuing nonperforming loan situation, a reduction of financial fragmentation across national borders, and improvement of the European fiscal framework.

The European Central Bank (ECB) also expressed a positive view of the Eurozone economies on June 21 as it presented its plan for scaling down its monthly quantitative easing bond purchases during the remainder of the year and concluding its Asset Purchase Program at year-end. The ECB indicated that its policy rates will remain at the present levels at least through the summer of 2019.

The HIS Flash Eurozone Purchasing Managers’ Index for June indicated that business activity regained some momentum after growth hit a one-and-a-half year low in May. The service sector was responsible for this improvement as manufacturing activity slowed further. Business expectations are depressed, with trade-war and political uncertainties cited as the biggest concerns.

Indeed, it is these concerns that have created the headwinds for equity markets during the second quarter. The worsening trade relations between the Eurozone and the US are a greater concern for Eurozone equity markets than for the US’s, as the Eurozone is more dependent on trade and on the maintenance of the rules-based international trading system. While Europe will respond in kind to trade restrictions imposed by the United States, its scope for doing so without harming itself are limited. If the trade war continues to escalate, the effects on the region will be dire.

Political developments in Europe also have created uncertainties that undermine investor confidence. The election of a populist government in Italy is seen as a threat to European institutions and increases the difficulty of reaching an agreement on an EU-wide solution to the immigration issue. While the election of the centrist Macron in France last year led to optimism that the populist tide had turned, populist, EU-sceptic parties have gained ground not only in Italy but also in Eastern Europe. Even in Germany, where Angela Merkel has been able to extend her leadership of the country, she is confronted with the difficult task of finding a position on migration that is acceptable to her coalition partner, the Bavarian CSU party, which is seeking to ward off competition from the right-wing populist AfD in regional elections in October. Polls indicate that immigration is the most pressing issue in the region and is a major driver of EU populism. An “immigration summit” of EU leaders last weekend was unable to make any progress.

Another source of political uncertainty is the negotiations on Brexit: Major issues remain unresolved, and time is running out.

It is not surprising, therefore, that Eurozone equity markets have experienced heavy going this quarter, despite the positive macroeconomic situation. Over the last 90 days through June 25th, the return for iShares MSCI Eurozone ETF, EZU, is -5.11%, which compares with a positive return of 2.22% for the SPDR S&P 500 ETF Trust, SPY. Within the Eurozone there is considerable variation in returns over this period, ranging from positive gains of 3.48% for the Global X MSCI Portugal ETF, PGAL, and 2.54% for the iShares MSCI Ireland ETF, EIRL, to large losses, with returns of -10.21% for the iShares MSCI Italy Capped ETF, EWI, and -12.53% for the iShares MSCI Austria Capped ETF, EWO. For the first and second largest economies, the iShares MSCI Germany ETF, EWG, returned -5.79%, while the iShares MSCI France ETF, EWQ, performed less badly at -2.65%. Trade tensions are likely to determine whether these markets are able to recover in the second half of the year.

Bill Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
Email | Bio


[i] http://www.oecd.org/eco/surveys/economic-survey-european-union-and-euro-area.htm
Sources: OECD, HIS Markit, CNBC, Bloomberg, Goldman Sachs Economic Research

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Tax Free Munis Continue to Perform

The tax-free bond market has continued to benefit from the drop in supply so far in 2018. To recap, the end of 2017 saw a bulge in supply as issuers tried to beat the tax-cut bill that Congress was still massaging through joint Senate/House committee work.

Cumberland Advisors - Tax Free Munis Continue to Perform

The final results of the bill were an elimination of advance refunding bonds but a continuation of private activity bonds. With the lack of clarity about aspects of the final bill, the supply of both advance refundings as well as private activity bonds mushroomed in early December, leading to a record amount – $63 billion[1] of municipal bond issuance – in the last month of the year.

The offset to the huge uptick in supply in December 2017 has been a drop in supply this year. Through the first five months of the year, new-issue supply has dropped from $161 billion at this time last year, to $126 billion. We have also seen demand pick up, particularly in high-tax states. Many states are seeing an increase in demand because, under the new tax bill, state income taxes as well as local property taxes are no longer deductible on federal taxes; thus the taxable equivalent yield for high-tax state bonds from California, New York, Minnesota, and other high-tax states has risen.

The relative improvement in the tax-free bond market can be seen in the table below.

Cumberland-Advisors-Tax-Free-Munis-Continue-to-Perform-Table01

As the Federal Reserve has continued to hike short-term interest rates, we have seen improvement in the tax-free muni/US Treasury yield ratios. The second quarter so far has continued a trend we saw in the first quarter, with yield ratios in the short end of the curve moving lower. Longer-term yield ratios have also moved lower, but the effect has been a little less dramatic than in the short end.All of this makes a lot of sense in an environment where shorter-term interest rates are moving up because the Federal Reserve is raising rates in the face of an ever-improving economy. If the average tax rate in this country is close to 25%, then only a 75% move in a muni tax-free rate is needed to equal whatever the equivalent rise in Treasury yields is. We believe the longer-maturity muni/Treasury yield ratios will trend lower as the Fed’s hike cycle continues into next year.

In addition, most tax-free yields are NOT on the AAA curve but usually decently above it, with most AA and A-rated bonds trading 40–80 basis points or more above the AAA curve. Thus the longer end of the tax-free bond market still offers superior value in our view. This is why we continue to employ a “barbell” approach to our fixed-income management, particularly on the tax-free side.

Below is a graph showing the US Treasury yield curve and the Bloomberg AA tax-free yield curve:

We can see that the muni yield curve is fairly well behaved from a ratio standpoint out to 7 years, then it cheapens and crosses the Treasury curve and yields continue to rise, even though the Treasury curve is lower – and flatter. One factor here is that longer Treasury yields have stayed lower ever since President Trump was elected. One of the reasons is that inflation has continued to be stubbornly low, and low inflation has been reflected in long Treasury yields, which have also stayed low. Another factor is that US government yields continue to be much higher that sovereign debt yields in other developed countries. In our view, the longer tax-free yields with yield ratios well over 100% provide a safe haven for bond assets if this ratio moves LOWER over time (as it did during the 2004–2006 period – the last time the Fed raised short-term interest rates). Thus we have the two parts of the barbell – on the one hand, owning shorter-term assets that can roll over quickly and be reinvested in higher-yielding short-term bonds as the Fed raises short-term rates. And, on the other hand, owning long-term munis, which provide much higher incremental yield than longer Treasuries do as well as short-term taxfree bonds. In addition, the cheap muni/Treasury yield ratios provide a life jacket to the duration risk of longer bonds. In other words, even if long Treasury yields rise, a return to a more normalized 100%-or-below yield ratio will buffer price erosion of longer tax-free munis.

Finally, a quick word about the Internet Sales Tax Decision announced late last week by the Supreme Court. The Supreme Court found that businesses did not need a physical presence in order for states to levy a sales tax in their respective states. Thus, sales of goods on the internet will now be able to be taxed, generally by the states in which they are purchased. The fact that we have Justices such as Justice Ginsburg and Justice Thomas on the same side of an opinion suggests that common sense prevailed here. Certainly, states that are more highly dependent on sales tax revenues will benefit from this ruling. The fact that the Supreme Court superseded its earlier ruling on this (Quill case) is also refreshing in that the Justices now recognize that technology has changed the original premise of the Court’s thinking. At Cumberland, we think this decision means greater debt service coverage for various sales-tax-backed bonds, and we would expect to see an improvement in their trading values.

And lastly, as we go to press, the US Supreme Court has ruled that government workers who choose not to join unions may not be required to help pay for collective bargaining.  Though this case was decided on First Amendment issues, it has broad positive implications for state and local governments to craft solutions to the pension issues facing them.  We will write more on this important decision in the next few days.

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio


[1] Figures pulled from Decade of Muni Finance, published by Bond Buyer.

 


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College and University Endowment Funds, Vanguard and the 60/40 Model

At the conclusion of each fiscal year, Commonfund and the National Association of College and University Business Officers (NACUBO) team up and publish a study analyzing the return and asset-allocation metrics across the country’s higher education endowment funds.

Cumberland Advisors - College and University Endowment Funds, Vanguard and the 60-40 Model

They refer to this annual analysis as the NACUBO-Commonfund Study of Endowments® (NCSE).[1] For FY2017 (July 1, 2016 – June 31, 2017), 809 colleges and universities participated. Institutions are organized by asset size and are placed into one of six categories (>$1 billion, $501 million–$1 billion, $101 million–$500 million, $51–$100 million, $25–$50 million, <$25 million). The largest number of endowments falls within the $101–$500 million range, with 275 funds represented. Below are the highlights:

 

 

 

 

 

Kinniry compared the returns generated by a globally diversified bond and stock portfolio within the classic 60% stock/40% bond construction against the returns generated by the NACUBO-Commonfund study. Kinniry’s global portfolio was designed and measured using indices, so no fees were associated with the theoretical portfolio. The 10-year average rate of return for this model portfolio of indices was 5.6%. The NACUBO-Commonfund endowment portfolios returned between 5.0% and 4.6%.

We can compare these returns to Vanguard’s Balanced Index Fund (VBINX), which comprises 60% domestic equity and 40% domestic investment-grade fixed income. This fund has a lengthy track record dating back to 1992. A link to Vanguard’s 2017 semi-annual report can be found in the third citation below[3]. On page 8 of the report, 1-year, 5-year, and 10-year average returns are reported. We encourage our readers to glance at these returns and compare them to the figures found in the NACUBO-Commonfund report. When working with nonprofits, small and large, to select an appropriate long-term investment strategy for perpetual funds, Cumberland continues to be a proponent of the classic 60/40 approach. For individuals and organizations seeking a long-term buy-hold-rebalance approach, Cumberland Advisors manages a strategy, dubbed Active Taxable or Tax-Free Bonds/Passive Equity that joins passive equity exposure (60%) with active bond management (40%).[4]

Gabriel Hament
Foundations and Charitable Accounts
Email | Bio


[1] https://www.commonfund.org/news-research/press-release/2017-ncse-survey-results-released/
[2] https://www.advisorperspectives.com/articles/2018/06/04/can-you-replicate-the-results-of-top-endowments?EXCMPGN=EX:PC:FAS:Sustaining
[3] http://www.vanguard.com/us/litfulfillment/ELFReports?categoryCd=PRRP&subcategoryCd=MFRP&view=default
[4] http://www.cumber.com/spiva-and-active-bond-management/


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Market Volatility ETF Portfolio 2Q 2018 Review

While the U.S. stock market had a long overdue correction in February of 2018, the first quarter ended merely flat eventually. Continuing from the rebound since February low, the stock market kept rising strongly in the second quarter.

Cumberland Advisors - Quarterly Review - Market Volatility ETF
 

Out of the three major indexes, the NASDAQ is leading the race by miles ahead. The technology-heavy index has closed at all-time highs for 20 times as of June 15 this year, piling upon last year’s record of 72 times. Although the Dow Jones Industrial Average had comparably 71 closing all-time highs in 2017, the Dow has only closed at all-time highs for 11 times this year, all of which were from January 2018. Moreover, the NASDAQ has also outperformed the Dow by roughly 10% including dividends during the first half of 2018. Standing in between the NASDAQ and the Dow, the popular benchmark S&P 500 has been relatively benign in 2018. Although this large-cap index has risen over 2% in both May and June so far, investors certainly have poured more interest into the small caps in the meantime, evidenced by the second quarter performance comparison below.


Chart 1. S&P 500 vs. Russell 2000 in 2Q2018. Chart source: Yahoo! Finance.

The second quarter has seen a lower volatility level compared to the first quarter. The VIX has calmed from above 20 down to 11 handle since April. Some major factors such as the alleviated concern over trade war and the improving U.S.-North Korea relations most likely contributed he significant downward shift in volatility. However, there are still some dark clouds in the near-blue sky. For example, the crude oil is still fighting to hold the $60-$70 per barrel ground. Not surprisingly, the oil volatility OVX has gone up in the second quarter.


Chart 2. S&P 500 Volatility VIX vs. Crude Oil Volatility OVX in 2Q2018. Chart source: Yahoo! Finance.

The recovery from the February correction has shown the resilience in the stock market. It is likely that the stock market can move higher in the next quarter if the volatility remains at or below the current level. However, as some sectors such as technology have demonstrated in the second quarter, not all sectors will be able to take advantage of the calming volatility equally this year. Perhaps, 2018 will be a year that favors active investors.

Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio


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