Overview
If the first five months of the year are an indication of what’s to come, we might be in for a volatile second half of the year. The strong gains of January quickly evaporated in February and March as fears of a trade war – particularly with China – began to dominate the headlines. As of this writing, the financial press is reporting that tariffs between the two countries “are on hold,” according to US Treasury secretary Steven Mnuchin.
This has been a long and sustained economic recovery of nearly 10 years, far longer than the average expansion of approximately 39 months (Investopedia). One of the hallmarks of the economic and market recoveries since the Financial Crisis has been the extended nature of each segment of the recovery. Think back to the early part of the recovery; it was referred to as an “L” shaped recovery – meaning basically not much recovery at all. A dramatic drop in economic and market strength followed by a subdued economy that still hasn’t sustained consistent growth over 3%. This slow but steady growth has been remarkably consistent and many economists expect it to continue into 2019 (Federal Open Market Committee Projections, 3/21/18).
Interest rates also have stayed exceptionally low for a long time. About the time the media and strategists were touting “lower for longer” in mid-2016, interest rates finally bottomed on the 10-year Treasury at roughly 1.37%. Since that time, rates have slowly but steadily climbed to about 3.1% today (Thompson ONE Financial data services, as of 5/29/18).
Because of these prolonged portions of the economic cycle, we believe many investors have lost sight of the fact that the cycle itself has followed traditional recoveries. Take inflation and interest rate expectations, for example. Traditionally, once inflation expectations bottom and begin to climb, traditional income-based investments often experience subpar performance. This stands to reason, as a unit of income in an inflationary environment is worth less in the future than today because it loses purchasing power. So, what has happened with income oriented investments since July ’16? The Barclays Aggregate Bond index has declined (price only) 7.1%, S&P US REIT Index is down 12.3% (price only), and Alerian Master Limited Partnership Index is down 19%. All this has happened in a period where the S&P 500 Index price return has gone up 31%. (Thompson ONE Financial data services).
The point is, this is classic later economic and market cycle activity (Richard Bernstein & Assoc.). What tends to do well in the portion of the cycle? The S&P 500 Financials (+54%), S&P US Industrials index (+35%), Bloomberg Commodity Index (+24%) are examples of the late cycle sectors that we believe make sense to favor. Of course, this part of the cycle will pass as well, and we will do our best to keep portfolios positioned appropriately.
Why Growth Matters
There continues to be much talk about the recent tax cuts, the long-promised infrastructure spending plan and deregulation. Intelligent people have very different opinions on these issues and we hear both sides of these debates from clients. All of these issues spill over into the conversation about the National Debt. Take a look at the chart below. Mandatory spending (things that are not negotiable without changes to law) plus interest on the debt make up 76% of the Federal Outlays. Include defense, and you are now at 88% of budget. That means that all of the budget fighting is really over 12% of spending – yes, that means we have a problem.
Source Agri-Pulse Communications, Inc. May 29,
It is really hard to balance a budget when only 12% of expenditures are on the table. One of the only viable solutions: grow the economy faster than anticipated and as a result increase revenues. Tax policy, budgets & appropriations all matter but none of them can solve the deficit issues except growth (Rick Santelli, CNBC 5/21/18).
Portfolios
Our model portfolios continue to be overweight equity and underweight fixed income. We also have a meaningful position in commodities in models. Within equities, we have a slightly higher weighting to international than domestic stocks. This is driven in large part by the historically wide valuation gap between US Stocks and International stocks. Currently, the forward PE ratio of the US Market is 16.6% vs Non-US stocks at 13.1% - nearly a 27% premium. Historically US stocks have traded at a premium to foreign stocks but the premium has generally been in the 5-10% range (Yardeni Research, Inc.). If these ratios revert to the mean, foreign stocks appear attractive to us.
Final Word
Many of you are aware that Steve’s wife is battling a serious illness. I’m happy to report that treatments and surgery have gone well and the results from tests has been encouraging. Please continue to keep the Altman family in your thoughts and prayers.
As always, we appreciate your support and trust.
Brett, Steve & Becky
