We all know the story of Wile E Coyote’s never-ending chase to catch and eat the Road Runner. Unfortunately, for Wile E Coyote, he never seems to quite catch the Road Runner no matter how hard he tries or what harebrained scheme he develops. He simply remains stuck in neutral.
The Global Financial Markets have been akin to the lovable coyote since late February. While there were times of advancement and limited success, markets have mostly been range bound over the last three months or so. For the year, the US Dow Jones Industrial Average is down slightly (-0.5%).ii The rest of the World’s markets have performed considerably worse and have lost 4.0% so far in 2018.iii
Bond investors have not seen much better performance in 2018 as the US Aggregate Bond index is down about 1.6%.iv While the International Bond Market has only produced a return of a little more than 1%.v The primary culprit in the benign performance from the US bond market has been rising interest rates. More on that later.
Obviously, investors in financial markets have seen little to nothing as far as growth is concerned in 2018. However, this does not necessarily mean that something is wrong, but rather just like ole Wile E Coyote we need to remain patient and persistent. Wile E Coyote did eventually catch the Road Runner, you know?vi Hope remains in place for us all!
Q3 & Beyond Outlook
US Economic Production
A significant reason that investors should remain hopeful in the return of growth to financial markets is that the US economy continues to show signs of growth like we have not seen in many years. Currently, the Atlanta Federal Reserve’s GDPNow model suggests economic growth in the 2nd Quarter of 4.5%!vii While we will not get the official Q2 GDP for many weeks that is a rather robust jump in economic production. Additionally, a healthy and growing US economy provides financial markets with a nice safety net.
We would further back that up with evidence that building/construction appears to be on consistent footing as permits suggests.viii In addition, the unemployment rate continues to hover at historic lows.ix Finally, the St. Louis Federal Reserve’s US Recession Probabilities projections currently suggest a virtually 0% chance of recession.x (NOTE: Historically, the warning sign of this model is when it suggests a 20% or greater chance.)
Overall, the US economy appears to be strong and growing. This provides us with a level of confidence that major storm clouds are not on the immediate horizon. As well as the last 3-4 months of market performance is nothing more than a short-term correction playing out after almost 15 previous months of uninterrupted advancement.
Global Stock Market Conditions
As we have discussed, global financial markets have mostly been stuck in a rut since February. As always, each country’s market performance is a little different. For instance, while US markets have at least held their own, the mainland Chinese stock market entered into a Bear Market recently (NOTE: Bear Markets occur when there has been at least a 20% drop from a recent high).xi This is of note, as the Shanghai Stock Market is one of the five largest exchanges in the World.xii
As for US markets, we would continue to suggest that in spite of being mired in a correction over the last 3-4 months there are few sectors of the market that are screaming buys based upon valuations. From a historical perspective, markets remain somewhat expensive or at the very least fairly priced.xiii In addition, according to Ned Davis Research, stocks owned as a share of total household assets are at the second highest level since 1951. The only other time there was a higher share than the current 41% was the early 2000s.xiv If consumers feel that they have enough of anything, they are less likely to continue to buy more.
Unfortunately, markets could remain range bound for a little while longer. Fundamentally, markets do not like surprises and uncertainty. Markets have been able to largely count on positive economic reports and solid company earnings, but there are several geopolitical aspects that serve as a bit of an anchor. One of which is the ongoing discussion of tariffs and trade wars, which we will discuss shortly. The other is the overhanging mid-term elections in November. Market participants want to at least feel like they know the direction that the ship is headed before they completely jump on board.
With all that being said, we still see potential for advancement as some of the geopolitical events work themselves out. One of our most consistently followed market strategist, Bob Brinker, stated in his June Marketimer® “In all 14 mid-term election years dating back to 1962, the S&P 500 Index has rallied 27% or more following the completion of the mid-term election year weakness.”xv Said simply, once investors know who is going to be in office for the next 2-4 years they have more confidence.
Global Trade War Possibilities
The significant economic news over the last 3 months or so has centered on trade tariffs imposed by the Trump Administration upon several trade partners. Many in the media are suggesting, or down right saying, that this is another example of Trump’s cavalier attitude and bull in the China shop, pun intended, approach. Trump’s tariffs have not been isolated to one particular country or region. In varying degrees, tariffs have been imposed upon goods coming from Mexico, Canada, China, the European Union, etc. On the surface, it would appear that the potential for a trade war is escalating. As many of the those countries have already or are suggesting that they will impose tariffs on American goods.
First, we would suggest that this is a bit of a political football for the Trump Administration. Tariffs have been most widely accepted in the Rust Belt area of the US.xvi Which area of the country helped propel Trump’s victory in 2016? The Rust Belt! As we discussed in our newsletters from 2016, Trump could not win the Presidency without winning some of those Rust Belt states. Is this a political strategy ahead of the mid-terms and in advance of 2020? Certainly is possible.
Second, truth be told, it is probably too early to tell if these tariffs will result in an all out trade war. There are a wide variety of opinions on whether a trade war occurs. Simply Google “trade war” and you can find countless articles written on both sides of the argument. We would suggest that the US does buy significantly more from China than we do from them. Therefore, the Chinese have potentially more to lose in a trade war with the US.
Finally, we echo our statement above that markets do not like uncertainty. The impact of these tariffs absolutely creates uncertainty. If you look at market performance on days when tariffs/trade wars have been the primary focus of media attention there is a high correlation between that news and poor market performance.
Federal Reserve Actions & Interest Rate Movement
The Federal Reserve hiked interest rates at their June 2018 meeting as expected.xvii The Fed Fund Futures are predicting another 1-2 hikes in 2018.xviii Should two additional hikes occur this year and longer dated bonds (i.e., 10-30 year bonds) not increase accordingly, the difference between short-term and long-term interest rates would be less than 0.50%. That is a geeky way of saying that there would not be much difference between the two.
So why is it important to keep track of short-term interest rates versus long-term interest rates? Because interest rates have an excellent track record of preceding recessions.xix In fact, an inverted yield curve (i.e., when short-term interest rates become higher than long-term interest rates) has preceded the last seven recessions. We tend to want to pay attention to something with that track record!
The good news here is two-fold: 1.) it would appear that based upon Federal Reserve projections that interest rates are still around 12-18 months away from invertingxx 2.) BMO Capital Market’s research suggests that it takes on average 15 months after inversion for a recession to hit.xxi In other words, as we sit here today we would continue to suggest that recessionary probabilities do not pick up dramatically for another 18-24 months. This lends further credence to our suggestion that the last 3-4 months are a correction AND that markets may still have some legs to run before a major downturn occurs. Obviously, this is not an absolute as things can change quickly.
When the yield curve does invert, we will communicate that with clients in an effective and efficient manner.
There is always noise in the economic world. There is always something to take advantage of or speculate on or to fear. We would suggest that clients remain focused on things that they have influence or control over. Spending and saving habits are probably two the biggest points of focus. Unfortunately, in long-term saving/planning there will be bumpy roads. There will be another recession and stock market crash. Probably sooner rather than later.
In summation, the economic/financial landscape currently appears relatively solid inspite of some noise. There is very little evidence of major economic or market breakdowns. Again, we would argue that there is a decent probability of another year or so before red flags really start to emerge. In fact, our fellow South Carolinian former Fed Chair Ben Bernanke recently stated, “the stimulus ‘is going to hit the economy in a big way this year and next year, and then in 2020 Wile E Coyote is going to go off the cliff.’”xxii Are two Wile E Coyote references in the same newsletter too much? Who knows, but we South Carolinians sure do see/hear a lot of these wily varmints.
Finally, we continue to beat the same drum: investors should not count on investment returns being the only source of growth for their accounts. Vanguard, the second largest asset manager in the World, recently stated, “US stocks will return about 4% annually through 2026, while non-US equities will return about 6.5% and global fixed income should return about 2.5%.”xxiii If these numbers hold true, it may be difficult for folks needing to earn 8-10% per year over the next 8-10 years to accomplish their financial goals. We would implore our clients to focus on areas that they have control and influence such as spending and saving habits. While financial markets can provide excellent long-term growth opportunities through compounding, don’t be dependant solely upon the whims of financial markets and geopolitical events.
Should anything change in our present thinking we will communicate accordingly.
We hope that you and your family have a relaxing and enjoyable Summer!
As always thank you for your continued confidence!
v http://performance.morningstar.com/funds/etf/total-returns.action?t=IAGG vi https://www.retroist.com/2009/06/09/does-wile-e-coyote-ever-catch-the-roadrunner/
viii https://www.nahb.org/en/research/housing-economics/construction-statistics/national/starts-and-permits.aspx ix https://data.bls.gov/timeseries/LNS14000000
x https://fred.stlouisfed.org/series/RECPROUSM156N xi https://www.bloomberg.com/quote/SHCOMP:IND
xii https://www.world-exchanges.org/home/index.php/monthly-reports-tool xiii http://www.multpl.com/shiller-pe/
xiv Hulbert, Mark. “This is What the Stock-Market Indicator with the Best Track Record is Telling Us.” The Hulbert Financial Digest. www.marketwatch.com. 22 June 2018.
xv Brinker, Bob. “Bob Brinker’s Marketimer.” Volume 33, Number 6. 4 June 2018. www.bobbrinker.com.
xvii “Federal Reserve Press Release.” 13 June 2018. https://www.federalreserve.gov/monetarypolicy/files/monetary20180613a1.pdf
xix The Federal Reserve Bank of Cleveland. “Yield Curve and Predicted GDP Growth, May 2018.” 28 June 2018. https://www.clevelandfed.org/our-research/indicators-and-data/yield-curve-and-gdp-growth.aspx
xxi Watts, William. “Here’s When The Yield Curve Poses a Danger to the Stock Market.” 28 June 2018. www.marketmatch.com
xxii Torres, Craig. “Bernanke Says US Economy Faces a ‘Wile E. Coyote’ Moment in 2020.” 7 June 2018. www.bloomberg.com.
xxiii Brandus, Paul. “Retirement Savers Should Lower Their Expectations, Says Veteran Wealth Adviser.” www.marketwatch.com 31 May 2018.