August 2018 – Monthly Commentary

August 2018

The U.S. economy continues to chug along with the second quarter growing at a revised 4.2% annualized rate.  That strength has carried into the third quarter with the Atlanta Federal Reserve forecasting 4.3% growth for the period.  That growth seems to have emboldened equity investors as the S&P 500 posted an all-time high of 2,916.50 on August 29th.  The index has since pulled back marginally, but all signs suggest that new records are likely with the release of third quarter earnings, set to begin only a few weeks from now.  Despite the ebullience of equity investors, the mood of Bond investors is anything but upbeat.  The 10-year and 30-year notes haven’t budged from the yield levels at which they sat in June.  Granted the short end of the market has shown some life with rates approximately twenty basis points higher for the same period.  With the Fed signaling two more rate hikes before year-end and a   continuation of hikes in 2019, one would think that rates across the yield curve would be higher.

Especially perplexing is the lack of movement in 3-Month LIBOR.  The reference rate is unchanged from the beginning of the summer and is actually three basis points lower than the recent high touched in May.  To be fair, there is a material chance that LIBOR will cease to exist at some point in the future.  For now, however, trillions of dollars of securities reference the LIBOR rate to determine their price, making it a critical benchmark.  Historically, in a rising rate environment, LIBOR has risen at a faster rate than Treasury bills as investors speculated on future rate hikes.  The TED spread, as the spread between LIBOR and Treasury Bills is known traded at an average spread of 30 basis point for much of the last five years.  However, following Jerome Powell’s elevation to Federal Reserve Chairman, the spread widened more than 60 basis points as investors began to discount a more aggressive rate hiking cycle.  That widening has reversed and has since narrowed to 21 basis points.  We believe the collapse in spread reflects a return of complacency by fixed income investors, and a belief that the Federal Reserve is close to the end of the rate hiking cycle.  We do not entirely agree with that logic.  Our forecast is that the Fed will raise rates later this month and again in December, followed by two more hikes in 2019.  Beyond that, forecasting becomes more challenging.

Year-over-year economic growth for 2018 is likely to be the fastest in some time but the bigger question is will it be sustainable into next year and beyond?  The short answer is that it’s not likely.  Tax cuts juiced the economy this year and we may feel the benefit into next year but the U.S. is a developed economy and with population growth of only about 1.0% and a de facto moratorium on immigration, current economic growth is going to be nearly impossible to sustain.  Perhaps, if taxes are lowered again, economic growth would accelerate, but that’s not likely to happen given the deteriorating fiscal state of the U.S.  What’s for sure is that at some point sequential growth, which is how the economist’s measure GDP growth, is going to be negative.  We have argued on numerous occasions that year-over-year growth is a better measure of activity as it compares “apples to apples,” but the convention in the United States is sequential comparison.  The policy reaction to that decline in activity is dependent on the cause of the downtick.  For example, we could have a robust Q4 2018 followed by a decline in activity in Q1 2019, especially if the country experiences a harsh winter.  In that instance, investors might not like it, but it would be no reason to call for a recession.  Growth would likely return in the next quarter.  On the other hand, if the decline is precipitated by a crisis of investor confidence, the stock market and its heady valuation could be at risk for a meaningful pullback.  As always, we remain vigilant to those risks.

July 2018 – Monthly Commentary

July 2018

The dog days of summer are upon us and the U.S. market has been relatively calm despite the daily barrage of news from around the globe.  That’s not to say that global macro events are not on the mind of investors.  Quite to the contrary.  Donald Trump’s trade war is making the headlines daily, the health of the European banking system continues to be a worry, and the drama of The United Kingdom’s divorce from the European Union is entering its third year with no agreement in sight.

Also on the minds of investors is the continued collapse of emerging market economies and the value of the currencies that they represent.  Quite often Investment advisors recommend emerging market debt as a way to diversify risk and add yield to a portfolio during times of calm.  We’ve written on numerous occasions that the additional yield is not worth the added credit risk.  The history of emerging market default is long and painful.  At the time of this writing, the Turkish lira is in freefall due to the political missteps of their questionably elected leader and his attempt to manage monetary policy.  Similarly, Russia again finds itself in the midst of a currency crisis based on the sanctions imposed by the United States. While that has pushed the value of the Ruble lower, the Russian economy is heavily dependent on oil revenue, and with the elevated level of oil prices the fallout is not nearly as bad as that of Turkey.

Also dragged down with the other emerging economies, the currencies of Korea, Thailand, and Singapore have all fallen versus the U.S. dollar.  The driver behind the Asian currency selloff is decidedly China.  The value of the Chinese Yuan versus the U.S. dollar is managed by the deep-pocketed Chinese government and has fallen nearly 8% in the last two months despite strict currency controls.  The Chinese government claims they are taking steps to slow the decent of the Yuan but it continues to lose value.  We believe that the devaluation is a thinly veiled attempt to retaliate against the tariffs put in place by the Trump administration.  Just three years ago, the International Money Fund elevated the Yuan to World Reserve currency status and yet the Chinese government continues to manipulate its value.  While not surprising, the IMF and its Chair, Christine Lagarde, have been mum on the subject.

As we wrote earlier, despite the perpetual diet of news, markets are enjoying a relatively quiet summer, with the S&P 500 index sitting just below an all-time high.  That performance comes on the back of another terrific earning season in which sales grew 11%, and operating income rose an “eye-popping” 26% versus Q2 2017 results.  What’s been conspicuously absent this season is the idea of “peak earnings” the media embraced to describe surprisingly strong Q1 earnings.  Were pundits embarrassed to have gotten the call wrong or has investor sentiment changed and the opinion is now that the U.S. economy has shifted into high gear?  We’re of the opinion that it’s a little bit of both.  The tax cuts enacted late last year are absolutely contributing to bottom line growth as corporations are paying less in taxes.  Moreover, they’re likely to support year-over-year growth for the rest of 2018 until comps become more challenging in April of 2019.

As the summer comes to a close and investors return to their trading desks, we expect that volatility will return.  The question, as always, will it be upside volatility or downside?