The Week Ahead – Please Don't Stop the Music

Welcome to “The Week Ahead” where we take a moment to provide our thoughts on what we can expect in markets and the economy during the upcoming week.

I read an article the other day that made my head spin. What would happen to the theoretical value of various long-term bonds if negative rates became a long-term economic feature rather than a short-term phenomenon? In this widely-distributed article, bond experts were talking about how even with ultra-low positive yields of about half a percent to 1%, that the value of those bonds could potentially be infinity. In short, buy today to potentially return infinity in a remote chance sub-zero rates could persist for long periods of time! Is this what it's come to now? People are trying to sucker others into paying high prices for long-term bonds yielding next to 0 or debt by presenting ludicrous arguments like that? Stretching maturity to 1,000 years? This invokes former Citibank President Charles “Chuck” Prince's now immortal-words in July 2007, months before Citibank was about to lose billions in everything from mortgages to credit cards: "As long as the music is playing, you've got to get up and dance."

"When the music stops, in terms of liquidity, things will be complicated." Words also uttered by Chuck Prince in July 2007 that seem most appropriate these days. With the S&P 500 P/E (LTM) at almost 21x and the EV/EBITDA ratio at 13.5x, these valuations leave little room for error. Over the past 30 years, the latter was higher only in 1999 (at 14x). The implications of a substantial increase in government spending and/or a material increase in the US corporate tax rate for equity markets seem to be of no concern as we prepare for a U.S. election in 2020. It appears that many investors are "dancing" and/or harboring fear of missing out on the next best thing these days as the age of easy money – what Chuck Prince referred to as "music" – continues. As US equity indices continue to hit all-time highs and US Treasury yields remain near all-time lows, the market does not appear to be factoring in the growing realization that negative rates are not a panacea, despite the recent acknowledgment by the ECB that negative rates erode bank capital and encourage excessive risk taking. Nor does the market seem to believe that U.S. rates are on hold, despite this week’s release of the October Fed minutes. When we look at what the Fed is doing, we think at best they are on hold for a while. However, as bond experts opine about rates continuing to go lower amid continued Fed easing, we ponder the thought, "If you are expecting/hoping for central banks to ease more, aren’t you in fact praying for an economic collapse?" If so, then I hope you don't own any equities. Better yet, you should be praying “DJ, please don’t stop the music,” as the cascading negative technical effects could easily turn investors currently “dancing” to “freaking out” in the streets.

Perhaps this week’s political theater where Gordon Sondland’s testimony stated "everyone was in the loop" is the epitome of today's investment environment. We know there is a contentious election coming. We know central banks globally have all but acknowledged the negative rate approach hasn't really worked. We know these things, yet market flows haven't abated and we remain invested. We are not panicking about next year, rather we wait opportunistically for volatility. Without the tailwinds from Fed (ECB and other central banks) easing, the upside in markets is likely to be more limited in 2020 and markets are likely to be more volatile. We expect to benefit from the volatility that we think is almost sure to abound in the months ahead.

Data deck for November 23–November 29: