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Investment Commentary

photoNovem­ber 5, 2018

Deficits and Mar­ket Churn

Philip Hergel, Senior Quan­ti­ta­tive Analyst

As we pro­ceed through the fourth quar­ter of 2018 we are expe­ri­enc­ing one of the most intense peri­ods of equity volatil­ity since this long bull mar­ket began in 2009. There are mul­ti­ple con­tribut­ing fac­tors at play includ­ing geopo­lit­i­cal ten­sions, expen­sive stock val­u­a­tions, ris­ing inter­est rates, and trade dis­putes. Region­ally, the Euro­pean Union exper­i­ment is start­ing to crum­ble with BREXIT sched­uled to hap­pen (or maybe not?) on March 29, 2019. The Euro­pean Cen­tral Bank is on the verge of revers­ing their unprece­dented mon­e­tary eas­ing pol­icy. Emerg­ing mar­kets are expe­ri­enc­ing their worst period of insta­bil­ity since the cur­rency crises of 1997. Chi­nese growth is decel­er­at­ing as author­i­ties strive to achieve a consumption-​based econ­omy. And in the U.S. eco­nomic and polit­i­cal uncer­tain­ties abound. As a result, we here at Zevin Asset Man­age­ment rec­og­nize that the out­look for global equity mar­kets has become increas­ingly risky through­out 2018 and par­tic­u­larly so in the third and fourth quar­ters of the year.

But what does this have to do with U.S. deficit lev­els? Sep­tem­ber 30 marked the end of the first full fis­cal year of Don­ald Trump’s pres­i­dency. It also marked the largest deficit that the U.S. has seen in six years (see chart). That’s not a coin­ci­dence. Impru­dent and unfunded tax cuts along with increased mil­i­tary spend­ing have led to a bal­loon­ing bud­get deficit. The Depart­ment of the Trea­sury recently announced, for the first time ever, the need to issue 28-​week bills. Again, this is no coin­ci­dence — the Trea­sury is find­ing it increas­ingly dif­fi­cult to man­age its bud­getary short­falls and is resort­ing to never-​before-​seen mea­sures to do so. It’s no sur­prise that the Trea­sury is on the verge of break­ing the record for the high­est ever debt refi­nanc­ing oper­a­tions. Inci­den­tally, the pre­vi­ous record was set dur­ing the Great Reces­sion, which was a time when it made sense to spend to stim­u­late the economy.

All this to say, the deficit is spin­ning out of con­trol with no sign of a rever­sal, con­sid­er­ing Pres­i­dent Trump’s lat­est sug­ges­tion of more tax cuts for middle-​income earn­ers. Ris­ing deficits do not directly con­tribute to short-​term mar­ket jit­ters, but in this case Pres­i­dent Trump’s response to crit­ics of his fis­cal irre­spon­si­bil­ity has intro­duced another source of unease. Trump con­tin­ues to attack the Fed­eral Reserve Bank for rais­ing inter­est rates “every time we do some­thing great”. But what he’s really say­ing is: higher inter­est rates make it more expen­sive to pay off my debts. Stop mak­ing me look bad. Trump would clearly pre­fer lower rates for longer to help bol­ster eco­nomic per­for­mance and also to keep the cost of ser­vic­ing the debt lower. He even went on to say he might have made a mis­take in nom­i­nat­ing Jerome Pow­ell as chair­man of the Fed. Now that’s a cause for con­cern! Finan­cial mar­kets like sta­bil­ity, and a U.S. Pres­i­dent inti­mat­ing that he may try to fire the head of his cen­tral bank is a major source of insta­bil­ity.

The inde­pen­dence of the Fed was estab­lished in 1951 so the cen­tral bank could pur­sue its objec­tives with­out being influ­ence by polit­i­cal pres­sures — just as Pres­i­dent Trump is doing now. There are two man­dates the Fed strives to achieve: sta­ble prices and full employ­ment. That’s it; that’s all. Both man­dates have been achieved and are at risk of exceed­ing their tar­gets. That is why the Fed is in tight­en­ing mode — they’re doing their job. They are also try­ing to pro­vide a cush­ion for when the next down­turn hits. And even still they are con­duct­ing what has been dubbed the eas­i­est tight­en­ing in his­tory (see chart). The Pres­i­dent is crit­i­ciz­ing mon­e­tary pol­icy because he’s in the hot seat over ris­ing deficits, which is one of many sources of the cur­rent mar­ket volatility.

Bot­tom Line: bud­get woes will be a major issue for years to come and will have neg­a­tive long-​term eco­nomic effects, as future gen­er­a­tions will be forced to divert funds away from pro­duc­tive projects to pay down astro­nom­i­cally high debt lev­els. In the shorter term, how­ever, the Fed’s march to nor­mal­ize rates will put con­tin­ued upward pres­sure on bond yields, mak­ing gov­ern­ment bonds as well as cycli­cal equity sec­tors rel­a­tively unat­trac­tive. The cur­rent administration’s response to the Fed’s tight­en­ing cycle has intro­duced yet another source of volatil­ity. Because of this col­lec­tion of height­ened mar­ket risks, since early 2018 we have reduced clients’ expo­sure to equi­ties while simul­ta­ne­ously explor­ing oppor­tu­ni­ties to allo­cate more towards defen­sive sec­tors and regions which we believe are more likely to out­per­form dur­ing this period of mar­ket churn.

Mr. Hergel cur­rently pro­vides the quan­ti­ta­tive mod­el­ing inputs which help to drive the asset, coun­try, and sec­tor allo­ca­tion deci­sions within our port­fo­lios. Pre­vi­ously, Mr. Hergel spent 12 years with BCA Research (for­merly the Bank Credit Ana­lyst), a well-​known and respected inde­pen­dent invest­ment research and advi­sory firm, where he was respon­si­ble for their econo­met­ric mod­el­ing efforts. Mr. Hergel holds an under­grad­u­ate degree in Sta­tis­tics and an MA in Eco­nom­ics from Con­cor­dia Uni­ver­sity in Montréal.