Surveying the Risk Landscape: Our Philosophy
At the end of every letter we write, we sign off by saying “We welcome your calls and questions.” Market turmoil and political events in 2018 have led to a number of questions from our readers and investment management clients. As we answer these questions, it often serves to highlight the investment strategy and philosophy we bring to you each week. This week, we thought we would share a few recent questions and our responses.
Many of them focus on potential or perceived risks in the global economy and global financial system, with readers asking why we remain bullish in the face of such risks. (Interestingly, few readers ask us why we aren’t more bullish given all the positive factors that also exist.) The answer is fairly simple. Some of the risks and events people fear are not realistic, in our view; and many are unlikely to be as severe as people fear. We believe those risks that are real and potentially severe are not imminent.
Economic downturns and the bear markets that come with them are as inevitable as the weather. Our investment strategy does not involve weathering such downturns and enduring the big declines; we prefer to hold cash or other safe instruments for our investment management clients during such periods. However, as we have pointed out time and again, bull markets typically deliver some of their strongest returns in their final phases.
We want to have an accurate picture of current and prospective risks, but we don’t want to miss most of the profit opportunities that often come during a bull market’s final appreciation — which we think we would if we kept focused on the negatives.
Question: Debt levels have been rising for U.S. corporates, and the quality of that debt has been falling. Could this make for trouble in a future downturn?
This is an issue we have mentioned often in this newsletter over the past year. It is true that the post-crisis years of very low interest rates have encouraged U.S. corporates to issue debt, and they have used much of the proceeds to buy back stock. It is also true that sometimes stock buybacks have been ill-considered, with some companies’ executives buying back stock not because it’s the most sensible thing to do, but because it will allow them to hit earnings-per-share targets and get more performance-based compensation. Corporate debt levels are being watched by the Fed, according to comments from Fed Chair Jerome Powell.
With all that said, we want to avoid being overly alarmed right now — and indeed, we think the trend could actually cause stocks to appreciate for some time to come, possibly for two more years. The corporate debt that has been issued has found ready buyers in U.S. pension funds — some of the world’s most influential investors. Pension funds are under pressure because so many are so severely underfunded. They are trying to make up for that underfunding by buying more high-yielding debt to boost their returns.
As we’ve written, the nature and legal standing of public pension funds means that more state and municipal tax dollars will be flowing into them, and that will mean more demand for corporate debt — and very likely, more buybacks. Corporates will issue debt for which there is demand, and with strong corporate profit growth, they will be able to service the debt they issue. This is the key: until corporate profit growth decelerates sharply, corporate indebtedness will not be a systemic issue.
As long as this trend of debt issuance and buybacks continues — and we believe it may accelerate before it reverses — it’s bullish for stocks. Again, we could see this trend continuing for another two years, although of course we are watching carefully for signs of a reversal.
In short, is corporate indebtedness an issue? Someday it will be, but that day is not today, and that day may not come for several years — years during which U.S. stocks may deliver significant gains, if past bull markets are a guide.
Question: Margin debt is high. Could this cause stocks to decline?
“Margin debt” refers to money owed to brokerages by those who borrow money from them to buy stocks. Levels of margin debt relative to the total size of the stock market have been range-bound since the recession at between 1.9% and 2.4% of total stock market value. We do not see that there is any alarming frenzy of borrowing currently occurring, and these levels are well below the levels of 2007.
Question: What about consumer debt and student-loan debt? Aren’t these alarmingly high?
Total consumer debt has also been range-bound, rising and falling during the post-recession period after a trough in 2009. With employment strong, discouraged workers returning to the workforce, and wages gradually growing, we do not believe the current consumer debt environment is alarming. Student loan debt, which is part of total consumer debt, is certainly elevated historically, and there are many reasons why the cost of higher education has risen so dramatically in the past few decades. Cogent policy responses are surely needed — but with most student debt owned by the Federal government, the issue is unlikely to be the catalyst for a future financial crisis.
In a nutshell, the U.S. consumer is doing well, and consumer sentiment reflects that. Consumer debt is not at worrisome levels.
Question: What about Fed tightening?
So far, the Fed’s gradual return to normalcy after many years of stimulation has been very gradual and very well-communicated. The yield curve — that is, the difference between long- and short-term interest rates — continues to flatten gradually. Over the past 50 years, this relationship has “inverted” — with short-term rates rising above long-term rates — before every recession. That’s getting closer, but it hasn’t arrived.
In short, the signs are that current Fed policy is not rapidly pushing the U.S. economy into recession. The path of the yield curve as it has unfolded so far is another point suggesting that a recession and bear market may still be one to two years away.
What about long-term problems with government debt and entitlements such as Social Security and Medicare?
We’re always in favor of smart policy solutions to difficult policy problems. While we care that solutions to these problems be found, the crunch is so far away that they are really not relevant for current investment decisions. We prefer to make sound decisions for the investable future rather than get too deeply involved in political discussion about developments that may not arrive for decades.
In general, we recognize these are risks. We find that a relentless focus on very long-term risks and problems can distort one’s investment psychology. It is worth considering long-term risks; however, we also do not want to discount the long-term economic strengths of a country with so many creative, generous, aspirational, self-reliant, and forward-thinking citizens. For 40 years or more, many have feared the underfunding of Social Security and Medicare. During that period, U.S. stocks have risen manyfold. We believe that Americans can find solutions to the pressing long-term social and economic challenges that face them. In the meantime, we will continue to look for innovative entrepreneurs building companies that help improve the quality of life for their customers and employees, and generate profits for their shareholders.
Investment implications: We believe that anxiety about the strength of the current economic expansion and the durability of the current bull market is premature. There are many variables to monitor, and in our view, they do not yet indicate that near-term recession risk is becoming elevated. Many concerns revolve around the health of credit markets and the condition of the consumer. We do not yet see signs of excess that should prompt investors to consider beginning to move to the sidelines. Indeed, some phenomena that are prompting anxiety — such as corporate debt issuance and stock buybacks — lead us to believe that these could intensify, and could contribute toward a final blow-off in stocks before the next recession hits. We do not believe that the current market phase is one for strategic caution. There will come a time to reduce exposure — but we do not believe it has arrived yet.
