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Investment views

Podcast: United States by numbers

26 July 2018
Author: Russell SilberstonPortfolio Manager

Russell Silberston, Portfolio Manager at Investec Asset Management, talks to Lindsay Williams on the US economy, the Federal Reserve Bank’s current interest rate policy and the global impact of trade wars.



Lindsay Williams: It’s Tuesday, so it’s the Big Picture sponsored by Investec Asset Management in Cape Town and this week we are going to go to the United States but we are going to go to the United States via the United Kingdom. We are going to speak to Russell Silberston, who is the head of Multi-Asset Absolute Return at Investec Asset Management in London.

I want to talk to you, if I can, Russell, about the United States of America and about interest rates because I am getting a little bit confused but let me get my little rant out of the way first. Why is Mr Trump trying to sort of degrade the integrity of the US Federal Reserve by putting a new Fed Chairman in and then saying why is he raising interest rates?

Russell Silberston: Well, yeah, absolutely. So one of the new phenomenons that we have to deal with as portfolio managers is the Trump tweet as he sort of wakes up in the morning and we see various headlines flashing through. The latest one was sort of saying ‘look here, I’m doing all this good work for the economy but actually the Fed are sort of putting up interest rates and it will slow the economy down’, all things being equal, you know ‘not good’ capital letters and that is what he is concerned about.

You know, he has cut taxes, he has put up spending and it was always the case that any central bank that operates as the Fed does is going to offset that with tighter monetary policy and the President obviously realises this and so he’s protesting but, actually, he’s not going to be able to do anything about it. As you just noted, firstly, he’s installed a new Chair and that Chair there is for I think [probably] eight years, so that’s not going to change anytime soon and, actually, the Fed report to Congress and so there is very little he can actually do about it.

Lindsay Williams: One of the more silly tweets. I mean I can understand the capital letters for Iran and I can understand the rocket man from months and months ago but this is a silly one because, if the economy needs to be cooled down for future generations or future generations of investors, then it must be cooled down. It is not slowing it down. It is just giving it a little break, which it might need in the future if inflation is going to rise and wages are going to rise, which gets me back to the fundamentals now. Let’s have a look at what is going on in the State at the moment – full employment for all intents and purposes but is inflation a threat and are wages rising?

Russell Silberston: Not really. I mean this is what is so interesting. So actually the big data release this week is actually [US] Q2 GDP and it is growing and this was a little bit of an estimate this far forward but it is estimated to be growing in the region of 4.2% in the last quarter. Now that is boom time compared to a trend rate of growth and all the Fed is trying to do is engineer a soft landing with modest inflation.

So, actually, inflation has been picking up (inaudible)… oil prices but their own projections sort of see it stabilising round about 2%, which is their target. Wages are a bit of a mystery. You know [bottom up], sort of anecdotally you hear of pressure in certain sectors but actually nationally wages are running a shade below 3% even though unemployment, as you know, is very, very close to historic low levels. That, to be honest, is a bit of an economic mystery.

I mean there’s a lot of theories around why that might be happening, from sort of interesting stuff such as the labour market is nowhere near as mobile as it used to be, i.e. people don’t move to get higher-paying jobs in other states, or even the impacts of large companies like sort of Amazon and if Amazon is the only employer in a city in Michigan, then actually people have got no choice where they actually work. This is quite an interesting concept.

So actually the models that one uses for wages are just breaking down in the current environment but, yeah, I mean the Fed I think are doing a good job and the economy is doing really well. It’s a bit of a sugar rush from those tax cuts and spending increases and they are just going to slowly but surely sort of grind interest rates higher and that is clearly up to the President.

Lindsay Williams: Yeah. What about the US 10 year in isolation and then the gap between the US 2 year and the US 10 year, which is something that people watch as a recession predictor? Let’s start with the 10 year.

Russell Silberston: Yeah, absolutely. So 10 year treasury was trading at just below 3% this morning. You may recall they got up to about sort of 3.10 earlier in the year and that is fine. As an asset, we think that is modestly cheap.

We think investors are positioned for higher yields, i.e. they have sold them in the hope of buying them back at a higher interest rate and we think that supports but it is quite hard for bonds to rally, i.e. prices go up, yield go down, when the economy is growing at sort of somewhere between 4 and 5%.

What is actually happening is that, as the Federal Reserve increase interest rates, the most sensitive bond maturity to those increases in interest rates would be those most closely aligned to official interest rates, i.e. the shorter dated maturity, sort of in the space of 2 years. The longer bonds reflects expected interest rates throughout the maturity of that bond, so a 10 year bond represents the market’s assessment of interest rates over the next 10 years plus a little bit of risk premium and inflation uncertainty and so on and so forth and the gap between those two has been collapsing.

It is now just over 0.3% and the reason there is so much focus on this is historically, when that relationship turns negative, i.e. 10 year yields are below 2 year yields, a recession isn’t far away and, if you think about it, it makes intuitive sense because what the market is saying is that expected interest rates are far too tight. 10 year yields are below 2 year yields, so there is an assessment that interest rates need to come down and the market as a voting machine is saying ‘Fed, you have overtightened’. This time around I am not convinced that is actually the message but that is certainly what people are nervous about.

Lindsay Williams: So we are 30 bps away from a predictor that has served us well in the past. I mean it has been fairly accurate, hasn’t it?

Russell Silberston: Oh absolutely! Without a doubt, pretty much every cycle has been sort of heralded by the yield curve but I do think, you know (a famous phrase) this time is slightly different and the reason is that obviously interest rates are very, very low still and so people are not sure the signal is going to be as powerful this time. It could be that longer-dated treasuries are being influenced by quantitative easing which, yes, it is being slowly wound down but that has had a big impact and it could be that there is a shortage of safe haven assets around the world.

So, yes, the yield curve is flat and then, yes, that reflects tighter policy from the Fed but I think the jury is out over whether that signal is still valid this time around. My personal opinion is it probably is because there is no doubt that interest rates by the end of this year would have been risen 250 bps, 2.5% and in any [tightening] that’s a significant amount.

Lindsay Williams: It is. Is there any chance that there could be a significant leaning on the Fed by Mr Trump, who is a persuasive character, and do you think that the autonomy and (again the word I used earlier on) the integrity of the Fed could be compromised and they might say ‘no, we’ll put interest rates on hold’ and that could put the yield curve all over the place, maybe to the detriment of asset class allocation in the future?

Russell Silberston: Absolutely. I would like to think not because they are very independent as they report to Congress not the President but you never know in the market about these things. If there is pressure, you never know if a decision say is particularly close, they may go down the route of no change. So we don’t know, to be honest, but the market again will vote against that. The market – any sign of central bank credibility being undermined will be punished by the market. Look at what, for example, happened in Turkey and the Turkish lira, which has completely collapsed as the President has been trying to undermine that central bank.

So, you know, there is a balancing act here and he can sort of kick up a bit of a fuss but, you know, his advisors will pull him back from really threatening the Fed but, having said that, don’t forget there are members of that Republican party that want to audit the Fed, there are people that want them to follow simple policy rules and so we can’t take this for granted.

Lindsay Williams: No, we can’t take it for granted at all and we can’t take for granted the bull market that has been in place in equities for 9.5 years. I know your speciality is not equities but, on the other hand, you can’t ignore things like the Alphabet/Google numbers that came out in the last 12 hours or so, which were pretty good and things seem to be ticking along quite nicely. The only thing that worries me (and this is a general statement) is that there is a concentration – just as there is in South Africa, with one or two stocks in the All Share Top 40 Index, there’s a concentration of drivers of the S&P 500. It is not exactly the most broad-based rally we have ever seen in the last two years.

Russell Silberston: No, that is exactly the case and we were just discussing this internally earlier this week. I think towards the end of last week it was only a few stocks that had really driven that index and we know which stocks they are. No, that is not a healthy thing but, you know, it is an index construct so it is mechanical in a sense but what is driving – I mean earnings are fantastic, right?

Lindsay Williams: Yes.

Russell Silberston: I mean earnings are increasing; expectations are increasing. The end of last week you had 20% of companies had reported, the majority being estimates and the earnings growth rate at Q2 was considered to be about a 20% increase. I mean that’s absolutely enormous.

What is driving that, of course, is the tax cuts and spending increases. We have seen corporate tax rates have been slashed and so I think, looking forward, whilst there are clearly name-specific angles here, generally the US equity market has been doing quite well and earnings are increasing.

You are quite right – it is very, very concentrated but it is what happens next because you have also got to think okay, well, is that in the price, are people positioned for that, and there is no doubt people are very, very bullish on the US and for good reason. As we said, it is growing somewhere between 4 and 5% at the moment but it is a very expensive market.

So we are sort of looking around, scratching our heads and going okay, where can we see better value; is there another way perhaps to play this, because the US, despite the best efforts of Trump, does not trade alone. There could be vulnerabilities. Perhaps if the dollar rallies powerfully, I suppose exporting companies could be under pressure. We have got the threat of tariffs. So, you know, things look great at the moment but we sort of question just how far this goes from here.

Lindsay Williams: Final question: what keeps you awake at night apart from the extreme heat in London at the moment, which is predicted to be 32/33 degrees over the next couple of days? Apart from the heat, what do you worry about? Do you worry about the trade wars? Do you worry about the leaders that are in place at the moment that use social media to put out their messages? What is it?

Russell Silberston: I think there are two things. The first one is clearly trade wars and I just think people have – I think one of my sort of themes I have been speaking about is the underlying issue, the underlying problem with the Global Financial Crisis was banks were too inter-connected … so when one went down they all went down.

What I worry now is the supply chain, the global supply chain is hugely integrated and, if we head down towards a trade war, that global supply chain is very, very vulnerable and so the sort of macro-economic effects of that could be quite severe, which is why I think common sense will prevail. Now that’s a clear issue that keeps me awake at night.

I mean Brexit is one we have talked about that as well but I think really that trade war is the one and then the final thing I think is this idea of the sort of quantitative tightening. You know, the Federal Reserve, not only are they raising interest rates, they are reducing their balance sheet and that balance sheet run-off is 50 billion a month from the Autumn (our Autumn) and that is a significant amount of money. No one has ever done this in economic history.

Lindsay Williams: It’s a huge amount of withdrawal, isn’t it? It’s a massive withdrawal of liquidity.

Russell Silberston: It is a massive amount, absolutely, and no one knows how that one is going to end and the Federal Reserve, they are watching it very closely but it is a big unknown. So I think, you know, Brexit has kept me awake for two years but the trade wars, global supply chain is the one and I think, as to the quantitative tightening, we are watching that very, very carefully. For now, actually, as I noted there, I think things look fine.

Lindsay Williams: A very good point on the global supply chain, by the way, Russell. Thank you so much for your time this evening. That is Russell Silberston, who is the Head of Multi-Asset Absolute Return at Investec Asset Management in London.


Important information


This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is not an invitation to make an investment and should not be construed as advice. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of Investec Asset Management. The value of investments can fall as well as rise and losses may be made. In South Africa, Investec Asset Management is an authorised financial services provider.

Russell Silberston
Russell Silberston Portfolio Manager

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