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Mike Moreland

July 10 , 2017

Summer 2017 Economic Market Commentary

ECONOMIC & MARKET COMMENTARY

This post is longer than most; a short explanation is due.

Each quarter our Division prepares an Economic & Market Outlook.  It reflects our investment view of the world, and helps shape our portfolio decisions.  We provide it to clients in their quarter-end statements as well; they have entrusted us with their financial success and deserve a look into how and why decisions affecting their portfolios are made.

Here’s the summer publication below.  Enjoy, and let us know if we can apply our principles to help you.

When you come to a fork in the road, take it.    

In addition to his accomplishments as a Hall of Fame baseball player and manager, Yogi Berra left us many lessons for life and, on a smaller scale, for participation in the financial markets.  The opening of this section is one such guide.  There are always differing outlooks, but it is incumbent on us to choose one and invest accordingly.  

It seems today we are facing three different paths – the outlooks offered by the Federal Reserve, the bond market, and the equity market.  Each is behaving in a manner somewhat at odds with the others.  Which one to choose?

Let’s take a quick look at each.  After going almost a decade without changing interest rates, the Federal Reserve raised its short term target rate once in 2015 and three times in the last six months.  Its stated plan to raise rates once or twice more in 2017 remains intact, and it recently introduced a plan to “shrink the balance sheet”; a reversal of years of bond-buying in multiple rounds of quantitative easing.

The Fed believes it is both feasible and necessary to take these steps.  Fed members view the current economic weakness as “transitory”, and use the same term to describe inflation remaining below its 2.0% target.  Its intention is to push short term interest rates to the 3.0% level, creating a “real” (inflation-adjusted) interest rate consistent with its long term expectations of 2.0% inflation and GDP growth.

The Fed is optimistic enough to raise interest rates now but is less enthusiastic about long term growth prospects for the economy.  It’s 2.0% long term outlook is about two-thirds of that recorded in the postwar era.  Times are different today, with an aging population, heavy debt loads among younger Americans, and slowing productivity growth.  Still, if this is the case, why the rush to normalize the rate environment?  The Fed believes the Phillips Curve – the interaction of inflation and unemployment – points to higher inflation down the road even if economic growth is capped well below its historic upper range.

So let’s call this the middle (or muddled) fork in the road.  Take it and you invest for slow growth and somewhat higher interest rates.  Longer term bonds and equities are expensive under this scenario, but not terribly so.

The future ain't what it used to be.      

Let’s follow the bond market down its path for a bit.  Bond yields have fallen sharply since year-end.  Longer term Treasury notes are back to the levels of last summer’s post-Brexit flight to safety.  There are two primary reasons for this turn of events.  First, global interest rates remain suppressed by weak economies and central bank actions overseas.  Even with currency risk, the U.S. bond market remains attractive to many international investors. 

The future ain't what it used to be.

The second reason is that market participants increasingly believe that tax reform and pro-growth fiscal policies will not appear anytime soon.  As such, economic activity and probably inflation will remain subdued relative to earlier expectations. This “lower for longer” perspective contradicts the Federal Reserve’s somewhat more optimistic view and its steps to raise short term interest rates.

The result is a flatter yield curve – the difference between two-year and ten-year Treasury rates is less today than at any point since Brexit.  And, historically, movement toward a flat yield curve is a precursor of slower economic growth.  If the yield curve inverts – short rates higher than long – that’s a good indication that a recession is around the corner.  We’re not at inversion yet, but the bond markets are headed in that direction.    

The bond market’s view is clearly the most bearish for economic growth and inflation going forward.  The guidance from this is to avoid risk assets, buy longer-dated debt, and wait for the Fed to reverse course.                                                                                                                                                                               

Nobody goes there anymore, it’s too crowded.                                                                                                                    

Equity market attention returned to the technology sector following the demise of the broad-based “Trump trade” earlier this year.  Market returns were driven in recent months by the “big five” – Amazon, Facebook, Microsoft, Apple, and Alphabet (the parent company of Google).  These issues generated nearly half of the S&P 500 thus far in 2017, and their success engendered additional buying by those following momentum and low-volatility themes. 

Nobody goes there anymore, it’s too crowded.

This concentration is known as a “crowded trade”.  Investors emphasizing technology today, beyond a nominal representation in the growth segment of a diversified portfolio, are betting the trend will continue.  It may, but history shows these periods rarely end well.  And, today, performance of capitalization-weighted indices is masking some troubling underlying trends. 

First, there is a clear divergence between the recent direction of economic surprises and the broad market.  Various entities monitor the difference between positive and negative surprises; that is, whether economic reports are above or below market expectations.  Stock prices usually follow.  This is logical; prices should rise with good news and fall with disappointments.  Most of the time this is the case; today is different.  A growing number of data releases have been below forecasts, yet markets continue to break records.  This pattern is unsustainable.

We see the same imbalance from a different but related view.  Over the long term, market performance essentially parallels earnings and dividend growth of its components.  Divergences signal periods of elevated opportunity or risk.  The current gap between market returns and underlying fundamentals is as wide as any point since the technology bubble nearly two decades ago.   

That the gap will be closed is certain; how and when is up in the air.  The most likely outcome is a combination of a market pause and gradual earnings advance.  This is the theme we adopted some time ago: stocks are expensive by historic standards and a reversion to mean valuations is probable.  At the same time, economic activity will continue at a reasonable pace, allowing earnings and dividends to maintain their forward progress.  Well-diversified portfolios, not those focused on the extremes of the spectrum, will provide the best combination of reasonable return with moderate risk.                                                                                                                     

Citigroup.jpg

If you don’t know where you’re going, you might wind up someplace else.

If there’s one argument for the value of comprehensive financial planning to meet long-term goals, this is it. Give Security National Bank Wealth Management a call to review your financial plan. Play ball!  

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