Crypto kept crashing and Trump keeps bashing; except for his pal Vlad.
The new tax cuts have bolstered US economic growth in this 9th year of economic expansion. Median forecasts for Q2 economic growth are 3.7%, much higher than Q1’s 2.2%. The policy may be good politics, and might be good economics; however, many economists believe late cycle fiscal stimulus is wasted ammunition against the inevitable recessionary forces that will occur at some point. Indeed, the “R” word is in vogue as the difference between the 10-year bond and 2-year bond narrowed from 1.0% to 0.25% in the past year.
This gauge is seen as a reasonable (not infallible) predictor of recessions because credit expansion is the life blood of economic activity and the root cause of boom-bust cycles: too much credit creates bubbles; too little creates recessions. Banks borrow short and lend long; their profits rise or fall with the size of the spread between long and short-term rates. If the spread is negative (meaning the 2-year yield is higher than the 10-year yield), recession probabilities rise. Simple to state, hard to predict.
Asset Class Review
Fears of higher tariffs and trade wars, in unison with rising interest rates and QE unwinding impacted several markets. Small cap stocks lead equity markets on the rationale they are less exposed to international trade and tariffs. International markets were hardest hit as the threat of selling into the US economy with higher tariffs and lower profits kept echoing from Twitterville. Emerging markets (EM) were hardest hit, reversing Q1 gains as the dollar continued to strengthen. News out of Turkey and Argentina sent a broader EM scare, even though Research Affiliates notes that Argentina is no longer classified as an emerging market and Turkey makes up less than 1% of all EM stock markets.
International markets, developed and emerging, remain priced at large discounts to US stocks. Janus Henderson research notes that Harvard, Yale, and Stanford endowments all maintain an overweight exposure to EM relative to the US stock market. In part due to lower valuation; in part due to higher long-term growth expectations. The US technology sector keeps rising in the face of very high valuations and now represents 23% of the S&P 500, 15% of the Dow, and 48% of the NASDAQ.
The GSCI Commodities index continued its strong momentum due to its 55% weight in oil; economically sensitive Copper is down over 16% for the year. US inflation reached 2.9%, the highest level since 2011.
Real estate values are rising yet REIT prices have struggled against the perceived threat of rising rates. REITs current yield is 5%-6% vs. the 10-year yield which began Q2 at 2.73%, spiked to 3.11%, and ended Q2 at 2.84%. The REIT spread is 2%-3% above the 10-year (vs. a long-term average of 1%). REITs were down 6.7% in Q1; up 8.5% in Q2. Lots of movement, with little action. Evidence of the futility in predicting market ups and downs: get the timing right; get the direction right; don’t forget tax ramifications and the implicit trading costs between the bid/ask on every trade. A lot of investment calories get burned on this treadmill.
Bonds had a difficult quarter. If rates move above the recent range, it would likely put more downward pressure on bond prices. Some strategists believe rates will double by the 2020 election due to rising debt issuance required to pay for the tax cuts; others believe that low inflation and low interest rates will be with us for quite some time due to demographic demand factors and the deflationary role that technology plays in keeping costs low for corporations and consumers. Simple to state, yet hard to predict the outcome because of all the factors that can determine the speed and direction of interest rates.
The Big Picture Review
Credit expansion has recently been exceeding US economic growth; if capital is allocated to productive purpose this has a multiplier effect that creates economic value. However, history counsels that extended periods of credit expanding faster than the economy leads to poor allocation of capital which can lead to bubbles. Household debt-GDP is one measure of credit expansion. By this metric credit levels appear moderately high at 75% of GDP vs. 2008-09 peak near 95%, according to the Bank for International Settlements.
It’s worth noting that early year forecasters were bullish on banks with the prospects for higher rates that deliver higher profits. The long-end of the yield curve has stalled after an early year spike. The big banks just reported earnings that were mixed, and their stocks are lagging the broader indices.
Will the tough tariff bluster turn into a real trade war that dilutes the benefits of tax reform? How will markets adjust if rates rise? Or if rates don’t rise? We can’t know how any of these things will play out with certainty, because every cycle is unique. Our strategy will remain focused on prioritizing the work that matters most: your time horizon, goals and spending needs; and managing the unique risks that are most important to your financial success.
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