The Fed
At the end of September, the Fed raised its benchmark federal funds rate for the third time this year to a range of 2-2.25%, and economists generally agree that one more rate hike is in order for December. FOMC members’ projections, which are reflected in the “Dot Plot” that we’ve discussed before, showed that most expect to lift rates by another whole percentage point through 2019 (through three gradual hikes). Many, ourselves included, are focusing on Fed Chairman Jerome Powell’s belief that interest rates are “a long way from neutral,” as well as his confidence in the current environment and the path forward. In other words, he believes we are still presumably several hikes away from interest rates being what in the Fed’s mind is neutral—formerly 3%, but possibly higher now. His optimistic sentiment seems to envision a historically unusual environment in which the unemployment rate remains under 4% and yet core inflation never gets too far above its 2% target.
Some economists are seriously questioning these inflation forecasts, but Chairman Powell insists the Fed will “stand ready to act with authority if expectations drift materially up or down.” He is confident that the central bank will be able to keep a handle on inflation by managing expectations so that any labor market surprises don’t have as much of an ability to shock the system. This is possibly why in part, according to Chairman Powell and the rest of the bank, the past several years have seen a divergence from an economic model known as the Phillips Curve (which shows that when unemployment falls, inflation rises). In this prolonged period of economic recovery, we’ve yet to see the associated rise in prices. However, Chairman Powell did at least state the importance of remaining skeptical “when forecasts predict events seldom before observed in the economy.” We have to say—we agree.
What’s Up with Treasury Yields?
When the economy is booming, stocks tend to do well because investors look to this economic growth to allow companies to grow earnings, and all else being equal, stock prices. The bond market has had a different experience, which has seen its prices fall for most of this year, in part due to rates rising (and we know that bond yields rise as prices fall). For several years now, the bond market hasn’t been seen as a great source of income by many (not by historical standards during other economic cycles). However, we’re now seeing a reversal of this trend. As risk-free rates climb in the Treasury bond market, the typical appeal to take on additional risk in the stock market to drive higher returns might be beginning to fade. Treasuries may be offering some risk-adjusted alternatives to the volatile equity markets. The 10-year Treasury note yield has hit five new highs this year. For the first time in a long time, Treasuries are yielding more on average than the dividend payments of the S&P 500 stocks. For some time now, stocks have managed to defy the rise in yields and have continued to grow in value themselves (the yield on the 10-year Treasury has more than doubled and the Dow Jones Industrial Average has gained more than 8,000 points since the summer of 2016), but there is some skepticism over how long this can go on uninterrupted.
So Why Have Stocks Continued to Fare Well?
Stocks have continued to rise because the economy is still healthy (September saw the unemployment rate hit its lowest level since 1969 and beat expectations for new private sector jobs added), corporate profits are even healthier, and corporate tax payments (under President Trump’s new stimulus tax deal) are down 40% from a year ago, driving corporate margins to historically high levels.
However, all of these factors come with important caveats to consider as we look ahead. We discussed above the potential risks to inflation with sustained low levels of joblessness, so let’s focus on the other topics.
The notable earnings growth that has driven the stock market’s prices this year is expected to slow next year, possibly by as much as half of the growth that is projected for 2018. Not every sector or every stock is currently expensive, but given the big picture scenario, the forward price to earnings multiple should probably be lower than it currently is, so as we’ve said the last couple of quarters, our expectations for mid-single digit returns next year suggests a rather unimpressive stock market. Also, it’s important to note that while the general mantra has been true that US stocks are doing well, a closer look reveals that valuations are being skewed slightly by two sectors (technology and consumer discretionary) and, beyond that, a handful of large cap growth companies that are carrying much of the index on their backs.
And lastly, we believe the positive impacts of the corporate tax cuts are likely fully digested, not to mention that along with the 40% cut in corporate tax payments comes with a substantial increase in government spending. So while the impacts on corporations have been favorable thus far, it’s important to remember that the stimulus didn’t happen free of cost. Moreover, a more recent quarter-end look suggests that global indexes may be beginning to outperform the US. We’ll discuss tariffs in the next section, but the US policy toward trade tariffs, especially toward China, could very likely make this scenario worse for US companies by raising companies’ costs and ultimately weighing on profits.
Global Outlook
It’s probably fair to say that global synchronized growth is no longer a theme that we’re seeing. The number of countries in economic expansion has fallen, as has the number experiencing accelerating momentum, to the lowest levels since early 2016. We’ve also been witnessing a slowdown in global manufacturing PMI (a leading indicator of economic health for manufacturing sectors), evidence of a slowing in international trade flows, for some time now.
It is of course difficult to say with certainty how the effects of a global trade war and ensuing tariffs will shake out exactly. Tariffs, though, almost by mere definition, interrupt global supply chains and naturally efficient systems of supply and demand. Trade wars are not to be viewed favorably—in fact, a recession is even a possible outcome of a fierce trade war between powerful players, albeit a worst-case scenario one. The tariff war of retaliation between the US and China in particular poses a great risk to our domestic and global economy. These taxes on imports could raise operational costs for US companies and therefore cut into profit margins. They could also further strengthen the US dollar which will hurt offshore revenues and lessen the impact of the tariff on the Chinese. Although the Fed has yet to see any real risk to inflation, this is another potentially impacted facet of the economy to keep an eye on. The risk, of course, is that all of this could ultimately strain US GDP and growth, as well as that of other countries, regardless of the desired impact on Chinese exports.
Perhaps one bright light on the global scene is oil, which saw marked strength in September, with Brent Crude (the trading classification for oil as a commodity) breaking above $80 per barrel at the end of the quarter and then above $85 in the first week of October. Of course, higher oil prices will take dollars out of consumer pockets, so while oil companies will certainly benefit from higher crude prices, higher energy costs will likely serve to dampen overall consumer spending activity.
Our Positioning
Our expectations are tempered and realistic for what the stock market is likely to bring in the months to come, and we feel we are postured appropriately for now. We do know that recessions and bear markets are part of the natural lifecycle of the market, albeit not always welcomed by investors, and certainly difficult and imprudent to try to time. We remain cautious and are therefore cushioned against a typical amount of market volatility, but if any additional risks become more substantiated, we’ll be poised and ready to act.
