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Remember the bond vigilantes? They ruled the financial markets in the 1980s and 1990s, sending interest rates sharply higher whenever they thought monetary or fiscal policy makers were getting too frisky, risking higher inflation or overly robust growth. James Carville, Bill Clinton’s political consigliere, remarked that he wished he could be reincarnated as the bond market because then he “could intimidate anybody.”
Those days are long gone, writes Jason DeSena Trennert, head of Strategas Research Partners. Purchases of trillions of dollars’ worth of bonds by central banks around the globe have sedated these former vigilantes into submission, pushing down long-term interest rates to historic lows. As a result, he contends, “it is doubtful that the bond market will do very much to scare the likes of the yahoos we’ve voted to represent us in Washington.”
The stock market, however, might be a different case. President Donald Trump rarely misses a chance to tout the major equity indexes hitting a record, along with job gains, on his watch. Trennert avers that the president may be able to take some credit for encouraging small businessmen, such as himself, by noting that at least taxes and regulation may not be getting worse, a theme touched upon in this space last week (“Trump’s Secret Weapon: Deregulation,” Aug. 19).
The flip side also might hold. “While the president seems impervious to the criticisms of a media he views as unfair and subjective, his obvious affinity for the Dow Jones Industrial Average may render stock prices a more important governor on the high-wire act the administration has become,” Trennert suggests. “A little less shtick and a few more legislative accomplishments might allow everyone to take a much-needed breather from politics.”
Maybe. The negative one-day reactions to the possibility of National Economic Council Director Gary Cohn starting an exodus of Trump’s core competent advisers after the chief executive’s reaction to events in Charlottesville is a stark reminder of the stock vigilantes’ power. Last week underscored the same. Tuesday saw a sharp rally in the wake of the president’s restrained, well-received speech late on Monday, while Wednesday saw a slip after he reverted to going off-script the night before in a Phoenix rally.
That “much-needed breather from politics” doesn’t seem a prospect for September, either. Washington will need to deal with the twin, but separate, issues of averting a government shutdown on Oct. 1 and a federal default if the debt ceiling isn’t raised before Uncle Sam is tapped out, probably by early October.
Deals should get done, despite the likelihood of a contentious relationship continuing between Trump and the two who should be his key GOP congressional allies, Senate Majority Leader Mitch McConnell and House Speaker Paul Ryan.
According to Chuck Gabriel of Capital Alpha Partners, “the odds of the Congress and White House avoiding a shutdown—at least in early October—may be 60% or higher. And the odds are even higher we’ll avoid any hiccup affecting U.S. debt.” Dislocations in the Treasury bill market, reported here last month (“T-Bill Yields Edge Up on Debt-Ceiling Anxieties,” July 22), last week caught the attention of other media and remain a lingering worry in the government securities market.
Chances are good for a continuing resolution to keep the federal government working through December, Gabriel adds. An increase in the debt ceiling of $550 billion to $600 billion would suffice to fund the Treasury until then (and presumably rebuild its depleted cash balances, which have been tapped as the debt limit has prevented net new borrowing since the spring).
To be sure, Republicans could squabble among themselves, and Trump could take shots at them, Gabriel continues. And the Democrats would be happy to let the GOP stew in its own juices. But Ryan and McConnell would want to avoid fights that could hurt Republicans up for re-election next year or that would upset the financial markets.
Trennert says that a 5% to 10% correction in stock prices might be needed to get Congress and the administration to cooperate. According to his Washington team, led by Dan Clifton, 2013 provides a template for the coming month.
Back then, “we were in a major rally, and people started to worry about September in August,” he continues. There also was a government shutdown looming and a possible debt-ceiling crisis; the Federal Reserve was expected to rein it its balance sheet; there was uncertainty about the next Fed head, and geopolitical risks loomed in Syria. Not much has changed, except North Korea poses an even greater geopolitical risk.
For the stock market in 2013, “late September/early October was a disaster, with a 4% decline. Subsequently, equities went up 17% in the fourth quarter,” he recalls. If past turns out to be prologue, September could provide a dip to buy, Trennert concludes. Then again, to coin a phrase, this time could be different.
That said, Trump is slated to hit the road this week to tout tax reform, according to a Financial Times interview with Cohn. Another political test for the president will be Hurricane Harvey, which was bearing down on the Texas coast at press time. The tragic fiasco of the George W. Bush administration’s response to Hurricane Katrina in 2005 exemplifies how not to deal with disaster. On both fronts, the stock market will be watching.
The financial markets also got no news from Federal Reserve Chair Janet Yellen’s much-anticipated speech to the annual policy conference at Jackson Hole, Wyo. Rather than a forward-looking analysis of central-bank policy, she gave an apologia for the actions taken since the financial crisis began in earnest 10 years ago this month. Yellen suggested that the regulatory steps taken in the wake of the near-meltdown have made the financial system far safer and more resilient.
Conspicuous in its absence was any mention of the most dramatic action by the Fed and other central banks, their aforementioned massive purchases of government bonds and other securities. These have injected massive amounts of liquidity around the globe, lowered interest rates to historic lows, and lifted asset prices to records.
One of the main modes of transmission of monetary policy is on the wane, however. That is via companies’ repurchases of their shares, which has shrunk the capitalization of the U.S. stock market by 17.5% in the past six years, according to a report by Société Générale’s GLE.FR -0.5338078291814946% Societe Generale (France) ADR U.S.: OTC USD11.18 -0.06 -0.5338078291814946% /Date(1503699600000-0500)/ Volume (Delayed 15m) : 147071 P/E Ratio 11.860893990901152 Market Cap 44914889749.3599 Dividend Yield 4.422441860465116% Rev. per Employee 560452 More quote details and news » European cross-asset research team, led by Andrew Lapthorne.
Corporations frequently issue bonds, which are snapped up by yield-hungry institutions, such as life insurers and pension funds, and use the proceeds to buy back stock. That shrinks the share count, and raises earnings per share and, presumably, the stock’s price, all else being equal. Given that executives typically are judged by earnings and stock performance, and that their stock options usually benefit, the brass tends to favor share repurchases over distributing cash to shareholders via dividends, he notes.
But Lapthorne finds that companies that do buybacks don’t enjoy better share-price performance. While repurchases are associated with cash-rich companies, they actually tend to have weaker balance sheets and poor profitability. Indeed, he finds it isn’t the big tech outfits spewing cash, but rather the general retail sector, with zero dividend yields, that are most associated with repurchases. “Buybacks are then a sign of financial weakness, and not strength, as is typically thought to be the case.”
The result is positive for the market, as investors selling shares back to the companies redeploy their cash to other, presumably faster-growing investments. And while Lapthorne doesn’t mention it, perhaps the cash from buybacks is recycled into exchange-traded funds, funneling more money into the stocks with the top market values.
In any case, companies are slowing buybacks at the greatest rate since the profit plunge in 2009, he continues, doing $100 billion less in the past 12 months than in the prior year. Adding together buybacks, dividends, and capital expenditures—the major outlays for a corporation—U.S. nonfinancial companies’ net cash flows have been in a record deficit, but funded by an accommodating debt market. “This importantly has started to correct itself, and reassuringly at the expense of buybacks and not capex,” he observes.
Two tax-reform proposals reportedly under discussion would tilt corporate investment decisions further in that direction. One would eliminate the deduction of net interest expense for businesses, raising the after-tax cost of debt. The other calls for full expensing of capital investments, which would allow an immediate tax deduction, rather than depreciation over the life of the asset. Eliminating the interest deduction would surely meet stiff opposition, while immediate expensing would hit tax revenue.
Getting a tax-reform bill by year end is a major goal of the Trump administration, Cohn said in his FT interview. Even before getting to such nitty-gritty details, the major questions about paying for lower rates while preserving politically popular deductions for charitable donations, mortgage interest, and retirement savings must be answered. And that’s after dealing with the debt ceiling and avoiding a shutdown, in Congress’ 12 working days in September.
In the coming month, the Fed also is expected to announce plans to begin its long-anticipated wind-down of its $4.4 trillion balance sheet, which Yellen has said should be as dull for the financial markets as watching paint dry. That would be just as well, given the excess of excitement in D.C., which the stock vigilantes might be forced to curb.
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