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Tuesday, October 30, 2018

We all know candy corn is mostly sugar. Investors may be worried about the robust economy running on a sugar high of tax cuts; after all, a sugar high usually ends with a crash. The latest GDP report of 3.5% growth in 3Q18 was better than expected, however, and was the fastest back-to-back quarterly growth in four years. We believe growth for full-year 2018 is firmly on track to reach 3%. Consumers were particularly sturdy during the quarter. Businesses struggled with the heightened risks in the trade tariff landscape; as a result, business investment (capex) faltered a little but was up a solid 6.4% year-over-year. Capex is important because it must increase in order to boost productivity and future growth.

Inflation moderated despite the strong GDP numbers. The PCE Index — an important inflation gauge for the Federal Reserve — moved back to 1.6%, below the Fed target of 2% and down from 2% last quarter. The economy is not at risk of overheating.

GDP details from Cornerstone Macro:

1. Capex was weak, but is likely to reaccelerate into 2019, i.e., 3Q18 was more noise than signal. Within capex, information processing investment was soft, as were structures, but industrial equipment and intellectual property investment were strong
2. Consumer spending was strong across the board. There might be a slight shift down in 4Q18, but the first half of 2019 could be supported by a significant shift up in tax refunds
3. Trade was a drag but inventories were an offsetting boost. Looking ahead, trade likely will continue to be a drag, but probably not as much as it was in 3Q18; inventories will stop being a boost
4. Housing was weak, but we believe it should pick up somewhat
5. Government spending will continue to support growth, reflecting the stimulus from April’s budget deal

Please follow GDP on page 71 of the Global perspectives Book.

Friday, October 26, 2018

The market is not done yet. Here are a few stats about corrections courtesy of The Motley Fool:

  • Corrections occur on average of every 357 days.
  • Between 1945 and 2013 the average correction was 13.3% and lasted 71.6 trading days (14 calendar weeks).
  • Predicting when corrections will occur regularly is impossible.
  • Corrections do not matter unless you are a short term trader.
  • Corrections are an opportunity to buy high quality stocks at a bargain.
  • Corrections are a reminder to reassess your holdings, rebalance your schedule and your overall plan for navigating volatile markets.

Corrections usually do not result in bear markets – an economic pullback which results in a hit to growth in company earnings. Recession is the primary cause of bear markets. Meanwhile GDP for the third quarter came in stronger than expected at 3.5%.

Please see the October 11 Global Perspectives blog, Stick to the Plan and Don't Fight the Fed.

Thursday, October 25, 2018

Housing starts were down, existing home sales were down, and new home sales were down. Housing and automobiles are two areas in particular that have been under stress. Automakers are facing tariff headwinds and their earnings are under pressure. Homebuilder earnings, on the other hand, are very strong. Nonetheless, the housing market has been showing cracks all year, even before interest rates jumped. Supply has not been able to keep up with demand. As a result, choices are scant and prices consistently have pushed upward, and are now on average higher than the previous high in 2006.

Housing starts have been hovering around 1.2 million, compared to 2.3 million new homes built in 2006. The S&P Case Shiller index has shown an average price appreciation of 6.5% this year, on the heels of 5.9% appreciation in 2017. Potential buyers have been increasingly reluctant to jump in and now that interest rates are rising, the paltry, overpriced inventory looks even less appetizing.

Housing is not poised for a crash, but it is not spurring GDP growth either. The malaise in housing may pressure the Federal Reserve to reconsider its continual upward path of interest rates. Unrelated to White House comments, the lack of a credible inflation threat and the deterioration in housing are valid reasons for the Fed to pause.

Please watch housing statistics on page 66 and 67 of the Global Perspectives Book.

Wednesday, October 24, 2018

Special Guest Blogger: Tim Kearney

The 3Q18 GDP report is due out this Friday (10/26) and consensus expectations are for a 3.4% growth rate, which would be good enough for a greater than 3% year-over-year growth rate. The Atlanta Fed NowCast calls for 3.9% growth in 3Q18, though the New York Federal Reserve sees just 2.1% growth. The Bloomberg Consensus of 76 economists sets the probability of a recession 12 months out at 15%, while the NY Fed’s yield curve only model has moved up to 14.5% over the past year, about the same as Voya’s recession model.

There will be those on the Federal Open Market Committee (FOMC) and elsewhere who will cling to the idea that this is a loose fiscal policy “sugar high,” which shifts GDP up over a couple of years and then sputters back to the “New Normal” growth rate. That is not my scenario, provided we continue to see renewed investment and productivity growth. Note that the World Economic Forum rated the United States the most competitive economy for the first time in a decade. As CNBC reported, “The U.S. was given a competitiveness score of 85.6 out of 100, with its strengths including business dynamism, its labor market, and the financial system.”

As I have been saying for some time now, the key is the evolution of investment spending to raise productivity. The FOMC minutes may reflect the first cracks developing in the New Normal edifice. The minutes noted “A couple of participants commented that recent strong growth in GDP may also be due in part to increases in the growth rate of the economy’s productive capacity…Participants noted that business fixed investment had grown strongly so far this year. A few commented that recent changes in federal tax policy had likely bolstered investment spending.” It appears we are set for some smooth sailing, though along with higher growth come higher interest rates – but for the right reasons.

Tuesday, October 23, 2018

The market volatility hits just keep coming, notwithstanding good news. Earnings season remains upbeat: as of October 19, FactSet reported that of the 17% of S&P 500 companies reporting 3Q18 results, 80% have beaten EPS expectations and 64% have beaten sales expectations. Nonetheless, even the companies that are nailing estimates and guiding higher are getting the cold shoulder from investors.

China announced more stimulus to prop up its economy but investors are not really buying it. They know monetary stimulus can only go so far and that it will take deep reforms actually to shift the world’s second largest economy into higher gear. In the United States, concerns center around profit margins due to higher input costs from tariffs, a strong U.S. dollar and Federal Reserve rate hikes. Investors have gotten especially jittery ever since they realized Fed Chair Jay Powell is serious about rate hikes (serious as in, “don’t make me turn this car around”). Earlier, they seemed not to believe it, despite lack of a credible inflation threat.

Bond yields jumped higher, and finally are becoming a compelling investment alternative to stocks; but not really, not yet. Even if bond yields move up to 4%, that implies a P/E of 25. The current 10-year U.S. Treasury yield of 3.126% implies a 32 P/E. Stocks are now valued at only a 15.8 P/E, based on their next 12 months of earnings. If you take the inverse of a 15.8 P/E, you get an earnings yield of 6.3%. Therefore, stock valuations are still more compelling than bonds. This is not to say that bonds are not an important part of a portfolio. They offer steady return, diversification and risk control, but they are not stocks.

Please see page 20 of the Global Perspective Book, The Fed Model, for a comparison of stock and bond yields.

Friday, October 19, 2018
Corporate earnings growth is the barometer for the health of the global economy.

Stock investors have had a rough ride lately. The top three culprits are the trade tariffs and their potential to erode profit margins, the Federal Reserve’s agenda for raising interest rates and slowing economic growth in China. A flare-up of yields in Italy and ugliness from Saudi Arabia aren’t helping. The auto sector especially has been in the crosshairs because of trade policy. What is not struggling is earnings growth; far from struggling on the stupid, smelly bus, they are riding a luxury cruise liner. So far, 80% of companies reporting third-quarter earnings have beaten estimates, reporting growth of more than 25%. What’s more, estimates for growth in the fourth quarter and in 2019 are looking optimistic. With earnings so good, it’s hard to understand why investors prefer the hot stuffy bus; in fact, the strong open this morning could actually lead to an up week.

Please watch earnings growth on page 6 of the Global Perspectives book and don't forget to register for the GP Quarterly Market Outlook Webinar!

Thursday, October 18, 2018
Asset class returns vary widely over time, making allocation decisions difficult and market timing success unlikely. Equal-weighted global asset allocation returns (“Global AA”) are shown for illustration.

Markets have been volatile and investors are still jittery. Yes, interest rates have moved up, but the Federal Open Market Committee (FOMC) minutes released yesterday indicate that the Federal Reserve (Fed) has not really become significantly more hawkish. The economy is indeed booming. The latest Job Openings and Labor Turnover Survey (JOLTS) of job openings reported an all-time high record high 7.1 million available positions. Initial jobless claims remain near a 50 year low. Regional manufacturing indices like Philly Fed and Empire State indicate healthy growth in manufacturing. Retail sales are at all-time record highs due to a strong and confident consumer. Markets, on the other hand, have not had their best year. Investors are jockeying for position, rotating in and out of sectors, styles and asset classes. This can be frustrating – like picking the wrong line in the grocery store, then switching only to find you are behind someone with a fistful of coupons writing a check. Having a solid plan for times like these can help investors sleep better. Markets go up and down but over time they follow the fundamentals – company earnings. Global diversification can help smooth some of the bumps, but there will still be bumps. Chasing last quarter’s or last year’s best performers is often the worst plan. Often the top dog in one year is in the dog house the following year.

See the colorful patchwork quilt on page 85 of the Global Perspectives Book and don't forget to register for the GP Quarterly Market Outlook Webinar!

Wednesday, October 17, 2018

Special Guest Blogger: Tim Kearney, PhD

It looks like Federal Reserve Governor Jay Powell committed a basic communication error that threw a shock into U.S. financial markets. At the Jackson Hole Symposium Powell seemed to downplay the ability of the Fed to discern in real time the “neutral” Fed funds rate (r*), i.e., the level of interest rates which neither inhibits growth nor stimulates inflation. He called for a risk management approach to monetary policy, rather than a rules-based approach; but his subsequent statement noted that the Fed could hike up to 50 basis points (bp) over neutral. While the comment raised uncertainty about his belief in neutral, his comment holds some hope as to intent: the Fed might go 50 bp above the current estimate of neutral, or it might be raising its estimate of the appropriate neutral rate. That is, higher growth might prompt a higher neutral rate than is necessary at present, suggesting that the Fed may remain accommodative for some time. It is a sentiment that I think the equity market would relish — once digested.

Since Jackson Hole, there has been pushback against the view that we cannot measure the neutral rate in real time, and neutral remains a useful concept. President Williams of the NY Fed and President Evans of the Chicago Fed both made comments implying that the Fed will not cut short its hiking cycle. Williams emphasized the existence of a neutral rate in the Wall Street Journal, noting “…our path today is getting us back to normal interest rates or neutral interest rates relatively quickly, over the next year or so.” Evans was rather hawkish, telling Reuters the Federal Open Market Committee “…could move to a slightly restrictive policy stance and, you know, probably pause at that point and see how things are going…” citing a target range above three percent. My view is that higher growth will lead to higher nominal rates, but the growth will come first. That sequencing is to the benefit of growth and risk assets over time.

Don't forget to register for the GP Quarterly Market Outlook Webinar!

Tuesday, October 16, 2018

On October 4, 2018, coincidentally or not, there were two stories describing China’s provocative policies toward the United States and the world. These were not sensational stories. One was from the Vice President of the United States given at the Hudson Institute and the other was the front cover and feature story of Bloomberg’s Businessweek Both of these read more like a highly confidential U.S. intelligence brief than something for public consumption. I highly recommend taking time to read both of them carefully. The news that keeps coming under the title “trade war” in the popular press and media has nothing to do with trade at all. I offer no opinion on this except to say that China is a very important part of the global supply chain and any disruption in this would have adverse consequences to global markets.

The Big Hack: How China Used a Tiny Chip to Infiltrate U.S. Companies” - Bloomberg Businessweek 10/4/2018

The attack by Chinese spies reached almost 30 U.S. companies, including Amazon and Apple, by compromising America’s technology supply chain, according to extensive interviews with government and corporate sources.

"Remarks by Vice President Pence on the Administration’s Policy Toward China" - The Hudson Institute 10/4/2018

Beijing now requires many American businesses to hand over their trade secrets as the cost of doing business in China. It also coordinates and sponsors the acquisition of American firms to gain ownership of their creations. Worst of all, Chinese security agencies have masterminded the wholesale theft of American technology –- including cutting-edge military blueprints. And using that stolen technology, the Chinese Communist Party is turning plowshares into swords on a massive scale.

Please see the Global Perspectives Quarterly Market Outlook and don't forget to register for the GP Quarterly Market Outlook Webinar!

Thursday, October 11, 2018
U.S. Financial Conditions Index

The markets got walloped Wednesday on a Fed that has been raising interest rates at the fastest pace in over a decade, and with expectations for more to come. In fact, the Federal Reserve has raised rates seven times since President Trump was elected. The Fed seems well within their mandate since unemployment is at a 49-year low, economic growth has jumped to 4.2%, corporate earnings are at all-time highs, and financial conditions are relatively easy (see chart). The Fed is arguably trying to keep in-line with an economy that is booming and to tamp down on excesses before they get too extreme. Yesterday’s “tech wreck” is a sure signal that things were trending toward extremes, and if anything the Fed likely will be proven correct with its “shot across the bow”.

The difficult aspect for investors is that their returns, which were not stellar year to date, just took another hit. Through the third quarter, performance of a diversified portfolio of stocks and bonds was up a dreary 1.7%. However, thus far in the fourth quarter through today:

  • S&P 500 large cap stock performance is -4.5%
  • S&P 600 small cap stock performance is -7%
  • Emerging Market equity performance is -8%
  • U.S. corporate bonds performance -1.5%
  • U.S. treasury 20 year + long bond performance is -2.75%

Wait a minute. Investors are so concerned about rising rates and their impact on bonds, but even long U.S. Treasury bonds are a hedge compared to equity performance. Yes: building a globally diversified portfolio of stocks and bonds can smooth out the volatility impact that investors’ experience. That is why we advocate to “stick to the plan” that you implemented during sounder times considering that market corrections happen – normally – two to three times per year.

In our quarterly outlook “The Economic Boom 10 Years after the 2008 Credit Crisis” we pointed out our concern about rising rates and the economy in sections:

  • “Economic Growth with a High Degree of Difficulty” reviewing the speed of the Fed rate increases and the resilience and strength of the economy despite the rate increases;
  • “Investors Pessimistic About Equities” reviewing that despite markets rising, especially in technology, inflows have been in to bonds over equities this year;
  • “Dollar Dread and Interest Rate Anxiety”, Rising rates have the ability to disrupt markets. Rising rates impact financial assets by lifting the implicit discount rate and puts downward pressure on earnings multiples.

Market corrections are normal and we last saw one in February 2018. Rates are rising because the economy is so good. This is not a Fed Policy mistake; we are just getting back to normal, and that is disruptive to markets. “Stick to the Plan and Don’t Fight the Fed."


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