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Fed cuts as expected, but not more of the same

Nov 6, 2019

• Fed delivers a cut, as expected
• The accompanying statement hints that further cuts should not be viewed as a given
• Low for long is the order of the day, as Fed sees little inflation risk in the system
• Easy money policy continues to fuel risk appetite while suppressing bond yields

The most recent Fed meeting yielded the expected rate cut: another 25 basis points. While it was quite widely discounted and transparently signalled, it has nonetheless had a somewhat positive effect on risk sentiment in the market, underscoring the market’s belief that the Fed will err on the side of stimulus.

However, we would concur with the Fed, for now, that there may not be any reasons to ease policy in the near term. That said, there is equally little to suggest that the reflation theme that animated markets in October is much more than just an indication that the late- cycle pause that we have been witnessing is moderating.

Equities showed an upward bias last week with the S&P500 ending 1.5% higher. However, what would you expect in a country when the central bank cuts interest rates and growth for the third quarter is still running at close to 2%. But it’s also surreal. The Fed HAD to cut interest rates because this expansion has at its core a massive increase in debt. Federal Debt has near doubled between 2009 and today to $22 trillion. The Fed is holding down long- term interest rates for fear that there could be a spike in long term interest rates that would hurt the government, indebted industrialists and households with mortgage and credit card debt.

We can argue forever that asset markets look expensive. Still, if the policymakers continue to feed the overvaluation of markets with easy money, the day of reckoning is put off yet again. As we end the year some of the near-term risks to markets look quite benign however you still have to ask yourself why we are in a negative interest rate world with rates in many parts likely to fall further.

The bias of our equity focus is on domestic growth helped by the lower interest rates, thus benefitting smaller and medium-sized companies.

The easy money conundrum has been stalking global bond markets for some time. The Fed’s recent call to reduce rates some more has not added much clarity to the longer-term question of what, if anything, will cause a “normalisation” of bond yields. The Fed has tried to take the position that the current set of data points does not warrant commitment to either tighten or loosen policy right now. The market has priced in a higher probability of a cut as the next move. The shape of the curve is still (more or less) positive, but the US 10Y yield is still below 1.8%.

For those who maintain that the huge reservoir of negative-yielding bonds is an affront to logic and that the situation will revert to the pre-crisis regime any time soon, the simple retort is to ask: What will be the catalyst? In the absence of any real indication of inflation, and with the global growth cycle showing increasing signs of vulnerability, why would one anticipate a spike in bond yields?

Even the bond bears have largely given up on inflation returning to the scene. Growth will be moderate next year, and possibly the after year that too. Central Banks are on cautious setting more or less everywhere, and in Europe and China likely more on easing mode than otherwise: in Europe, there are clear growth concerns, and China is alert for weakness driven by the trade war.

Instead, the argument goes along something like monetarist lines: a flood of money will eventually lead to inflation, and its current absence is merely temporary. Central banks are exhorted to hike rates to get on the front foot for the next downturn, given there is no space to ease policy from current levels if there is indeed a more severe slowdown in store. This argument looks a bit circular: rates have to rise to protect the economy from a time when they will have to fall again. Really? If the economy is not up to dealing with higher rates now at a time of reasonable US growth, what hope for the economy if the Fed was trying to deal with stagflation?

It is a good thing someone else is in charge of the Fed because this problem looks intractable. The growing US budget deficit compounds it. A mildly slowing economy this year and next will not help the US make its budget target. It would have been tough going at a 3% GDP pace; at 2% to 2.5%, the idea of budget discipline looks quaintly far-fetched.

For private investors unconstrained by the regulatory framework faced by banks and insurance companies – who are among the larger holders of negative-yielding bonds – the simple strategy is to avoid sovereign debt. In the realms of investment-grade debt, high yield bonds and some emerging markets, there is still enough bonds that are trading on reasonable yields; no need to dabble in Swiss or Japanese paper where one’s capital erodes.

As I head off to the Web Summit in Portugal with 70,000 exhibitors, and investors in attendance focussed on new ideas, companies and technology, there remains a positive vibe in the venture capital market. A recent report by NVCA showed that while US VC activity is largely at the same level as last year, there is still much capital to be deployed. The deal value should again hit a healthy $100 billion for the year. While there have been a few disappointments in the pre-IPO market, there were $200 billion of VC-backed IPOs in 3Q. 65% of the exits are in $100 plus deals.

Saudi Arabia has announced the IPO of Saudi Aramco after much delay, the government is aiming to raise $60bn for the 5% stake placing a top-end valuation of $2 trillion on the company. The company will set out on a roadshow in the coming weeks. The company will list solely on the Saudi stock Exchange the Tadawul. The company has already committed to paying a $75bn annual dividend in the first year. A 3.25% dividend yield would be at the very top of integrated oil majors. There is much debate about the valuation of Saudi no doubting that this is a monumental step in the modernisation of Saudi Arabia and the vision of the Saudi Crown Prince Mohammed. Local investors are likely to be very supportive of the issue even if out of nationalistic pride. The issue embodies a vision of the future of Saudi Arabia that is of scale and international standing. No one should understand how big a deal this is for the political leadership and the standing of the country in the international community.

UK Election

Regardless of whether down to vanity, a cunning strategy or sheer frustration, the current, highly criticised and celebrated UK parliament is finally about to end, and the electorate goes to the polls on December 12th for the third time in 40 months. At this point, the odds seem to favour a working majority for the incumbent Tory party, allowing it to pass the amended draft Withdrawal Agreement by the new deadline of January 31st. The majority of opinion polls, as the campaign kicks off, suggest a double-digit percentage lead for the Tories over the Corbyn-led Labour Party. On most criteria, Boris Johnson is indeed the preferred leader. Yet, as with all things Brexit, nothing is to be taken for granted. The electorate is in an angry and very volatile mood. The British Election Study suggests that between 2015 and 2017, a third of voters switched parties while 43% changed in 2015 compared with 2010. At this stage in the 2017, Mrs May had a lead of over 20%, but it largely evaporated in the subsequent bruising campaign.

We draw readers’ attention to the following tentative observations:

· Boris Johnson must win a working majority (20 seats plus) to deliver Brexit. The objective of the Remain opposition will be effectively met if he fails to do so.

· Unlike the May 2017 general election, the smaller parties will start off on the front foot, especially the Liberal Democrats and the Scottish National Party, as they send out a strong Remain message.

Gary Dugan
Johan Jooste
Bill O’Neill (Consultant)

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