Zeller Kern’s Investment Monitor

Pensions, Deficits, and the “Fed”

July 11, 2019

By Steve Zeller                           

It has been a while since our last publication of the “Investment Monitor”, March 25th, to be exact. We have been working on a number of major projects, internally at our firm, and continue to do so. However, we’ll try and sneak in an issue in, now and then, to keep you informed on our thoughts on the market.

The entire ten-year cycle has really come down to monetary authorities permanently nationalizing the risk calculus for the investor class. – David Rosenberg (July 3rd, 2019)

Are you feeling confused about the condition of the financial markets because the stock market keeps climbing, yet the tariff war remains well in-place, yet the economy is being heavily celebrated, yet Wall-Street is begging for Fed Chairman Powell to lower the “Fed Funds Rate”, yet the Fed continues to reduce the assets on its balance sheet, yet the yield for the 10-Year Treasury Bond has declined from its October 2018 high of 3.22% and now sits at 2.05%( That’s a decline of 36%), yet debt continues to stack up globally, yet the President is bragging about the greatest economic expansion, yet global growth is contracting and European 10-year bonds, such as in Germany, are sporting negative yields, yet investor optimism still hovers near all-time highs? - You’re not alone, it is confusing.

It doesn’t make sense. So, we thought we’d offer some thoughts and opinions, backed up by data, to help explain why things are the way they are, even though it sometimes feels like insanity, or is.

The major indices of the U.S. Stock market have recently reached new highs. This is all while the rate of change of growth for corporate revenues, profits, economic expansion, and inflation, have all been slowing. Historically, that is very bad for stocks – And it might prove to be so in the near future, but it’s certainly hard to tell. So, if growth has been slowing, and a number of economic indicators are downright crashing, why does the market keep climbing? Well, there are a number of things to blame it on, which include, a record level of share buy-backs, investor sentiment at very high levels, and continued manipulation of capital asset prices by the Central Banks around the world. Plus, keep in mind, that the majority of the volume of shares of stock that is traded, is done so by “algo driven machines”, so to speak. Also, keep in mind, and we have mentioned several times in the past, that a bull-run in the stock market that runs this long, ten years plus, investors sensitivity to risk all but vanishes.

But something else is in place that is historically unique, and has crept into place in the last 10 or 11 years, and that is the Fed’s position of being completely committed to propping up the stock market, and really it is all the major central banks. But why is that? Well, I can offer a few reasons: First: It’s the pension funds. During the last 10 years, plus, the Fed has been committed to artificially propping up the economy by implementing round after round of QE (Quantitative Easing), to where the net result is very cheap borrowing costs. Unfortunately, because it has been very difficult, until the past year, to make any money with Treasury bond yields, institutional investment funds, such as pensions, have been forced to primarily invest in the stock market, or equities in general.

One can be confident in saying, that if the markets decline significantly for a sustained period of time, the pension funds will be in big trouble. We can also easily conclude that if that were so, the Fed Chairman would panic and do what’s necessary to prevent that from happening.

The Second reason is the bloating of the Federal debt, soaring deficits, and the diminishing demand by foreign investors to buy our Treasury bonds. This forces the Treasury and the government to rely on the “private sector” to carry more of the water in providing tax revenue to finance the deficits. In other words, if the government can’t simply issue more debt to pay for the deficits, because of diminishing demand, it has to come up with the money elsewhere. The private sector has been providing these funds through taxes generated from IRA withdrawals, capital gains from investments and so forth. Plus, the economy is being driven from proceeds made from investment account profits. Therefore, if the stock market goes down, for a sustained period of time, you can speculate that the “Fed” would be motivated to jump in to prop it up. So our Fiscal condition and our economy is becoming more and more dependent on a rising stock market. This is complicated to explain, and I might be missing a few things in this explanation, but that’s generally what we’re dealing with, arguably.

This type of unprecedented behavior creates radical distortions in the markets and arguably takes us away from the concept of Free Market Capitalism – A Fed driven stock market and economy is not Free-Market Capitalism. It also makes the job of “tactical investment managers very difficult, because trends can reverse on a dime from central bank manipulation, when historically, their decision-making system would tell them otherwise. Tactical money managers, including managed futures funds, hedge funds, etc. have had a heck of a time producing attractive results, while still managing risk. Historically preceding this perverse Monetary Policy, these managers did considerably better.

As was noted in the statement above that David Rosenberg made recently, accurately sums this up by saying that “the entire ten-year cycle has really come down to monetary authorities permanently nationalizing the risk calculus for the investor class.”

Share buy-backs have been in force for the last several years. But these last two quarters (Q1 and Q2 of 2019) have been mounted to insane levels. If it weren’t for this, it’s hard to say where the market would be, at this point. At a minimum, the Fed would be very busy. Then again, if we get into trouble with corporate earnings, we could see a shift from share buy-backs to raising cash and reducing debt.

Sure buy-backs are great for shareholders, but there may be other motives by central banks to encourage them. Also, by artificially holding down borrowing rates, many corporations have been borrowing to buy-back their shares. According to an article on Klinger.com, companies in the Standard & Poor’s 500 Index repurchased $806 billion of stock last year, up 55% from the previous year, and 37% from the record set in 2007. Goldman Sachs expects S&P 500 firms to spend $940 billion on buy-backs in 2019.

The rise in market indexes during the past week, was driven significantly by defensive sectors within the Dow and S&P 500, such as Utilities, Staples, REIT’s and Health Care. Meanwhile, economic trends globally and here in the U.S. continue to weaken. As our readers may recall, we were calling for an economic slowing to enter the scene starting in the fourth quarter of last year and to continue through this year. That appears to be the case, with the June Global Manufacturing PMI posting at 49.4, the worst reading since 2012. German Factory Orders for the month of May were down -8.6% year-over-year, and U.S. Factory Orders were down -1.2% year-over-year, the worst reading since August of 2016. New Orders posted a 42-month low. The PMI chart below, illustrates all of the components of the Index, with all of their rates of change slowing, except for employment and production. Furthermore, additional charts below that analyze the PMI data also indicate that the economy is in a slowing trend.





Given our outlook, since last September, for a slowing growth rate for the economy, corporate revenues, and profits, we have had a biased for Federal Treasury Bonds, and Utility stocks. Right in line with our expectations, utilities have been strong during this period, and so have Treasuries.

Dow Jones U.S. Utilities Index – 1 Year


10 – Year U.S. Treasury Yield – 1 Year


If the market begins to get into trouble in the near future, we continue to expect Treasuries and Utilities should continue to do well or at least hold their value. Some of the other indexes have not fared as well in the last 12 to18 months, including the Russell Small Cap Index, the MSCI International Index, and the Emerging Markets Index, as illustrated below.

Russell 2000 Index - 1 Year


MSCI International Index – 1 Year


MSCI Emerging Markets Index – 2 Year


S&P 500 Index – 1/1/2018 – 7/5/2019


The S&P 500 hit another all-time high on Wednesday of last week, however, finished the session up with just a .3% gain. The interesting fact of this milestone is that the index was driven up largely due to defensive sectors such as Utilities (+1.2%), REITS (1.8%), and Consumer Staples (+.8%). This could get rather interesting as we head into earnings season with corporations posting earnings results for the Second quarter. The challenge for them is that their Year-Over-Year comparatives will be a significant challenge, because earnings for the second quarter of last year was the second best on record; and with earnings growth slowing, we could find ourselves in an earnings recession. This should cause a lot of pressure for the market. Additionally, if you look into the third quarter, a continued slowing of earnings growth would create an even bigger challenge because, earnings for the third quarter of last year was the best on record.

Nothing is of certainty, the best we can do is to follow a lot of data very closely, and the data is suggesting that we are continuing to slow. Whether or not Fed Chairman Powell lowers rates in July, remains to be seen. If earnings get into enough trouble, we expect that he will. A lot of the members of Chairman Powell’s inter-circle within the private sector is of the Venture Capital ilk. The Fed Chairman past employment was the Carlyle Group, which is a Venture Capital Juggernaut. If the corporate sector gets into enough trouble, one can speculate that his peers would be demanding that he moves to lower rates. Whether that would influence him enough is hard to tell.

Then there is the possibility that President Trump and Chinese President Xi could strike a productive trade deal. That could have an immediate impact on the markets. But many critics highly doubt that will happen, anytime soon. In our view, it will come down to the trends of the economic cycles, and whether the rate of change for growth continues to decelerate or not.

Stay tuned to Q2 earnings as they are beginning to be released. We’ll see how they hold up, not on expectations of analysts, but rather, how their growth rates actually pan out.

Looking back on last week

Last week's action was busy in spite of the holiday-shortened week, which was able to produce substantial gains for the equity indices. The S&P 500 climbed 1.7% for the week while the Nasdaq outperformed, rising 1.9%.

Monday's session featured the response to Saturday's meeting between President Trump and China's President Xi Jinping. While the meeting did not yield concrete steps toward reaching a trade deal, it also did not lead to an escalation of the dispute. Instead, President Trump agreed to relax restrictions on sales of components to Huawei and decided to not impose additional tariffs on imports from China at this time.

While market started strong, the markets quickly faded after the opening on Monday, but because of the compromise with Huawei, the Semiconductor Index was up 5% at the start but faded to close up 2.7 on the session. Meanwhile the balance of the week the index continue to give up their early gains finishing only up 0.2%.

Friday's reminder about continued growth in nonfarm payrolls reduced expectations for an aggressive rate cut, which in turn pressured stocks and Treasuries from their best levels of the year. At the end of the week, the fed funds futures market saw just a 4.9% implied likelihood of a 50-basis point cut in July, down from 32.3% one week ago. The implied probability of a 25-basis point cut remained at 100.0%.

Best Wishes,

Zeller Kern Investment Committee