The second quarter has been in many respects a continuation of the first quarter wherein financial markets have provided investors with little or no return on their investments. Today’s markets appear bewildered and subject to relatively sharp moves based on news stories and political maneuvering. Rising interest rates, potential trade wars, geopolitical concerns (populism, EU difficulties, sanctions) and a growing fear that the end is near for the long, but weak, economic expansion in the US all bear some responsibility for the confusion. Markets are driven by fundamentals and by emotions. Fundamentals such as sales, earnings, cash flow, dividends and interest rates are data driven and thus can be easily measured, at least looking backward. Trying to project companies’ fundamentals or economic activity into the future is a more difficult exercise because emotions can cloud the picture. When they are in some sort of balance, fear and greed will keep markets in check. When too many investors lean toward one side or the other,markets become unbalanced and subject to wide swings, corrections or rebounds. Today, it appears that investors are not too greedy, and given the still low level of interest rates and the current valuation in the stock market, neither are they too fearful. However, investors are clearly nervous and seem to have a heightened sense that something is about to happen.
The data that we and others watch are mixed. On the positive side, economies around the world are generally doing quite well, although some are doing much better than others. Interest rates are still historically low even though they have been rising. In the US corporate earnings have been strong, due in part to tax reform enacted last year, but also because revenue growth has accelerated and operating profit margins are up strongly. Inflation has risen in the US to above the Fed’s 2% target which is a good sign that our economy continues to normalize. Unemployment now matches its lowest point in half a century and consumer confidence has risen close to levels experienced in the 1997-2000 period. Finally, geopolitics, while quite contentious, remain largely non-violent. This is the “glass half full” explanation of today’s landscape. For the “glass half empty” readers, we have added some of their arguments in the table below.
Our interpretation of the data is that economic growth, at least in the US, will continue for a minimum of several more quarters. The positive factors mentioned above should provide a tail wind which will push economies forward despite some of the pressures that seem to be appearing on a more regular basis. The question on everyone’s mind is: How long will the expansion last?
Interest rates are a very important factor in any forecast. Interest rates in most developed economies are still very low as indigestion from the 2008-09 Great Recession lingers. Exiting the grand experiment of quantitative easing/low interest rates that central bankers developed a decade ago is proving to be more difficult than many probably hoped.
At their core, interest rates depend on the rate of inflation. Central banks such as the Federal Reserve control short-term rates through monetary policy. If the economy becomes overheated, the Fed will raise rates until people will no longer borrow money. Alternatively, lower rates usually increase spending and investment and thereby boost economic activity. While short-term rates are set by the Fed, long-term rates are based primarily on investors’ expectations of future inflation. Historically, the 10- year US Treasury Note has yielded 1 to 3 percentage points more than the 3-month US Treasury Bill which reflects investors’ requirement for a margin of safety for locking up their money for 10 years instead of just 3 months. The chart below shows the difference between short and long-term rates for the past 70 years and, as can be seen, when the curve has approached 0% or gone negative, a recession soon followed. The only exception was in the mid 1960’s. This indicator is being watched very closely because the Fed has announced its intention to continue to raise short-term rates. Full employment and the strength of our current economy may be reason enough for the Fed to continue tightening, thereby raising the probability of a recession. A counter argument to this scenario is that long rates are artificially low—a product of the Fed’s buying $4 trillion of bonds in the past decade as part of their quantitative easing program. If they were to decide to sell a significant portion of those holdings, that added supply would raise long rates toward what might be considered more normal levels. Therefore, some people may question whether this yield curve predictor is still valid. Our view is that it is, but that the curve may need to turn negative instead of just approaching 0%, and the timing of a recession may be delayed versus what is suggested by the chart.
Tax reform gave corporations an immediate boost to their reported earnings but easing of the regulatory environment has probably been even more important for future growth as companies begin to think about expansion rather than just trying to maintain what they have. That said, earnings growth will slow from its unsustainable pace and as it does, investors may view it too negatively. Economists and markets have been watching for signs that companies will invest at home. While it has only been six months since passage of tax reform, capital spending as reported in S&P 500 company filings was up 22% in Q1 2018 versus Q1 2017. Nonresidential fixed investment was up 7.1% in Q1 2018 which compares with a 2.7% year-to-year change on average in the first quarter since 1999.
Th e current level of profit margins are another area of concern. For the S&P 500 Index, operating profit margins are at the highest level seen for at least a decade, but probably for much longer. This is partly due to businesses simply doing much better than in the past, but it is also due to the changing makeup of the index itself. Information technology accounts for a much larger part of economic activity than in the past and this sector has much higher margins.
The recently released minutes of the Federal Reserve’s last policy meeting discussed whether recession lurked around the corner and expressed concerns that global trade tensions could hit an economy that by most measures looked strong. The minutes gave the impression of a central bank impressed by the US economy’s strength and confident in its plans to continue raising rates, but also concerned with what could push the economy off its upward course. Trade tensions were high on that list. Also, on the list was the slope of the yield curve, about which they apparently spent some time discussing and agreed that it would be important to continue to monitor.
In summary, we believe that investors should stay the course with current asset allocations. Worries and caution flags exist, which we see as a healthy sign. If we sensed true complacency, we would counsel a great deal of caution; if irrational fear paralyzed most investors, we would recommend being more aggressive. While uncomfortable, today’s environment of tensions, worries and potential problems is one in which investors should actually find comfort.