March 25, 2016
By Steve Blumenthal

“Corporate sector metrics have been disappointing of late… Companies are scaling back expenditures of all kinds (capital expenditures, hiring, and inventory-builds, for example), as their top-line revenues and earnings decelerate.  Though first-quarter numbers may come in better than beaten-down forecasts, firms are finding that top line revenues are still hard to grow significantly.”  Rick Rieder, Head of Global Fixed Income, BlackRock

As you see in the next chart, increased corporate debt loads place profits at risk.


It’s profits we need to worry about especially when valuations are high.  This is a headwind to further market upside.

If you want to get a good sense for why high valuations lead to poor future returns, I wrote a piece this week for Forbes titled, “Plump P/E Ratio Suggests Subdued Stock Market Returns Ahead.”  Click here to go to the article.

The point is that debt is a drag on profits.  It is concerning now but will be even more concerning  if (scratch that) when interest rates begin to rise.

So it is forward we must set our gaze.

Chicago Fed President Charles Evans said Tuesday that two rate steps this year are “not at all unreasonable,” while his colleague from Philadelphia, Patrick Harker, said he would like to see policy makers tightening borrowing costs “a little faster.”

St. Louis Fed President James Bullard said policy makers should consider raising interest rates at their next meeting amid a broadly unchanged economic outlook and prospects of inflation and unemployment exceeding targets.

Bullard added, “I didn’t want to be raising rates further in an environment where we had declining inflation expectations,” he said. Since mid-February, “they have bounced back up” so “that is making me feel better. We are moving in the right direction.”  Source

Three steps and a stumble is an old rule on Wall Street.  That means the Fed raises interest rates three times in a row.  NASDAQ defines it as a rule predicting that stock and bond prices will fall following three increases in the discount rate by the Federal Reserve.  This is a result of increased costs of borrowing for companies and the increased attractiveness of money market funds and CDs over stocks and bonds as a result of the higher interest rates.  Frankly, I recall the rule to be two steps and a stumble but hey, birthday number 55 is knocking on my door.

Three steps seem to make more sense to me today as our starting place was from an unprecedented 0%.  Rate hike number one is behind us.  The Fed is fighting to create inflation (as are the other suspects: ECB, JCB and China’s Central Bank).  All in, including the U.S., they make up over 70% of the world GDP.

I wrote about Henry Hazlett recently and shared my thoughts on inflation (here) and agree with this next statement from Bullard, “I think we are going to end up overshooting on inflation.”

“Now these monetary institutions are expected to continue producing miracles.  But their ability to repeatedly pull new rabbits out of their policy hats has been stretched to an increasingly unsustainable degree.”  Mohamed A. El-Erian, The Only Game in Town

And just a few more quotes from El-Erian’s book:

“…they have become single-handedly responsible for the fate of the global economy. Responding to one emergency after the other, they have set aside their conventional approaches and — instead — evolved into serial policy experimenters.

Often, and very counterintuitively for such tradition-obsessed institutions, they have been forced to make things up on the spot.  Repeatedly, they have been compelled to resort to untested policy instruments.  And, with their expectations for better outcomes often disappointed…”

Untested policy instruments.  The markets seem to be somewhat smoothed by the Fed “Put” (the backstop for the market).  However, I think that floor is thinning.  Forward we must march.

Today, let’s keep it short.  I share a great opinion piece from David Zervos.  He talks about the détente agreement between the ECB, the JCB, the Chinese Central Bank and the Fed.  I think he is spot on.  The world is awash in unmanageable debt and the chemists are playing with the mix.

I also touch on the deterioration in credit ratings, a 15-year low.  What is the catalyst that ignites the debt bomb?  My two cents is that it is when inflation and interest rate expectations begin to move higher.  I conclude this weeks piece with a few portfolio construction ideas in Trade Signals.

Enjoy your long weekend.  Wishing you and your family a wonderful Easter.  Thank you very much for your interest in On My Radar.  I hope you find it helpful.

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Included in this week’s On My Radar:

  • She May Be the Best We Have Ever Seen, David Zervos, Jefferies
  • Average Corporate Credit Rating Hits 15-year Low
  • Trade Signals – Nearing Extreme Optimism

She May Be the Best We Have Ever Seen, David Zervos, Jefferies

Janet’s performance yesterday was nothing short of stellar.  She delivered what was no doubt the most dovish message of her entire central banking career, and she did it without a single communication mishap.  Her message contained three key points:

  1. The balance of risks for inflation is lower, and there should be no concern associated with any temporary inflation overshoots.
  2. Employment gains have been strong, but there’s still more work to be done in bringing excess labor market slack back into the workforce.
  3. The international situation poses a great danger to financial stability and thus should be a key factor in determining the timing of future monetary policy moves. (SB here: bold emphasis mine.)

Now to be sure this was not an easy message to convey. The unemployment rate sits almost on top of the NAIRU, and all the major core inflation measures are straddling the target of 2%.  A simple rule from the fresh water macro crowd would be screaming for rate hikes towards 3-4% rapidly.  But thankfully Janet has treated those nugatory recommendations appropriately!

She was at the G20 meeting in Shanghai.  She understood perfectly well that the Chinese monetary policy link to the US “directly” extends the reach of Fed policy far beyond the US borders.  And she has surely been scarred (like we all have) by the PBOC moves of August and January.

Thus, in my opinion, Janet fully complied with the “détente” concept which we have been writing about in these notes for many weeks.  She called off the DXY rally, and implored her colleagues at the ECB and BoJ to do the same.  And as we saw over the last week, both institutions complied!!  Everyone at the G20 table realized that monetary policies involving a currency devaluation by the Europeans and Japanese, or monetary policies involving currency appreciation by the US, would be counterproductive.

They would unleash a full-blown CNY devaluation – something that would make the August and January moves look like child’s play.

So where do we stand now?  Well, the Europeans and Japanese will basically be leaving interest rate policies alone.  Mario dumped forward guidance, and Kuroda drew a “theoretical” line in the sand at -50bps for

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