3 of 2019’s Key Financial Surprises

repo market - 3 of 2019’s Key Financial Surprises

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2019 has brought a series of major developments which have transformed how key parts of the U.S. stock and bond market work. And those came as a surprise to many, but not to all.

Allow me to go through a few of them and how they will help you to profit in 2020.

Surprise No. 1: Inflation

Source: Chart by Bloomberg

Leading into 2018, inflation gave indications that it was going to be a problem for the U.S. economy and market. The core Personal Consumption Expenditure Index, which tracks all consumer spending and prices, quickly headed toward and above the 2% level from March through the peak in July. That 2% level was important as it was what the Federal Reserve and its Open Market Committee were — and still are — using as a benchmark for inflation.

This, along with some other missed data and mistakes by the FOMC, led to series of hikes in its target range for Fed Funds (the rate at which member banks lend to one another). But as 2019 got going, the PCE fell and has remained very low at the current level of 1.6%. That’s well below where the FOMC was targeting.

This has led to a major reversal of FOMC policy which has worked to direct market interest rates much lower. The key to what was and continues to happen is that consumers, which are the major drivers of the U.S. economy, are flush with choices for all sorts of goods and services. This continues to drive prices ever lower.

The plethora of choices is showing little to no signs of reversing. And the key beneficiary has been the overall U.S. bond market. As measured by the Bloomberg Barclays U.S. Aggregate Index, the bond market has returned 8.6% year-to-date, trumping many years’ worth of records

Source: Chart by Bloomberg

This should continue to fair well into 2020. One of the easiest plays to continue to cash in on the U.S. bond market is the closed-end fund, BlackRock Credit Allocation Income Trust (NYSE:BTZ). It has a cross section of government and corporate bonds, yielding 7.3%. And it trades at a discount to net asset value of 8.2%.

Surprise No. 2: The Collapse of the Repo Market

Source: Chart by Bloomberg

Another big mistake that surprised the Fed and the FOMC was the collapse of the repo market in 2019. Repo stands for repurchase agreement. These agreements are how banks and major financial institutions fund overnight and short-term liquidity. They’re one of the lynchpins of the financial markets. A repo works when one financial sells bonds to another and agrees to repurchase it back at a set time and price. The difference between the sale and repurchase price is the implied interest rate.

The trouble came this fall as the U.S. Treasury sold a large series of bonds that soaked up cash. It was no surprise as the Treasury posts its schedule. But the FOMC didn’t prepare and repo rates spiked into the double digits until the FOMC stepped in.

The real problem has been building in that major U.S. banks have been strangled from their core operations — making corporate loans and participating in the capital markets. The Dodd-Frank Act of 2010 made these core operations almost impossible. And further regulatory actions through 2016 further imposed troubles for banks. Even with legislative relief in 2017 and regulatory changes from 2017 to date — much has still not been completed.

And with the normal expansion of the financial markets, the crisis was going to happen. The result is that the Fed is now the bank for much of the shorter-term liquidity in the U.S. markets.

And this should continue into 2020. Short and intermediate interest rates are not aiding net interest margins, so continue to avoid U.S. banks. Additionally, regulatory woes are driving bank costs higher, driving the efficiency ratio (the percentage of cost for each dollar of revenue) higher as well.

The way to benefit is through alt-financials — which are not banks but still do the business of lending. One of the best is Main Street Capital (NYSE:MAIN) which lends primarily to middle-market U.S. companies. Yielding 6.7% including regular special dividends, MAIN is a good performer with a return year-to-date of 37%.

Surprise No. 3: Corporate Bonds Are the Old Way to Borrow

Source: Chart by Bloomberg

The U.S. bond market did very well in 2019, as noted earlier. One of the best segments has been corporate bonds. Low inflation and good demand were beneficial for corporate bonds — but one of the surprise drivers was the lack of supply of new issues for much of the year.

The result has been a good corporate bond market with a return year-to-date of 14.3%, as measured by the Bloomberg Barclays U.S. That’s well above the general U.S. Aggregate Index as noted earlier.

Source: Chart by Bloomberg

Aiding the lack of new issues is the rapidly expanding market for privately placed corporate loans. These are loans placed without the costs of massive filings typically required by publicly traded corporate bonds. This makes them easier and cheaper to get done. And eager buyers are gobbling them up — both lesser credit-grade bonds and investment-grade bonds.

This market has done well for 2019 and I see it continuing to outpace corporate bonds and corporate lending. One of the best ways into this market is in TPG Specialty Lending (NYSE:TSLX). Structured as a business development company under both the Investment Companies Act of 1940 and the Small Business Investment Incentives Act of 1980, TPG Specialty Lending participates in the loan market.

It is significantly aided by its association with the TPG Group (formally Texas Pacific Group), a leading global private equity investment group. TSLX yields 8.4% on an annual basis including regular special dividends. And it has returned 30.1% year-to-date. TPG Specialty should continue to generate rising revenues from the developing loan market as it further grabs more of the corporate funding market.

Neil George was once an all-star bond trader, but now he works morning and night to steer readers away from traps — and into safe, top-performing income investments. Neil’s new income program is a cash-generating machine … one that can help you collect $208 every day the market’s open. Neil does not have any holdings in the securities mentioned above.

Article printed from InvestorPlace Media, https://investorplace.com/2019/12/3-2019-key-financial-surprises-inflation/.

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