— 2019 Q1 Update —
SUMMARY & HIGHLIGHTS
Quarter one of 2019 was much better for investors when compared to quarter four of 2018. It was defined by high returns and low volatility, whereas quarter four was exactly the opposite. The question is, will it continue? Signals that point towards the bull market continuing are hopefulness regarding the US-China trade war and lowering credit spreads (indicating less underlying credit risk in the economy). Signals pointing towards the other direction is the yield curve inverting while the Federal Reserve is attempting to unload an unprecedented amount of assets off their balance sheet.
- POSITIVE TRENDS in the first quarter of 2019
- A SLOWING DOWN of the Federal Reserve’s interest rate hikes
- RECORD HIGH budget deficits and bloated balance sheets
- IMPACT of slow-down in credit and reduction in liquidity within the economy
Please continue reading the detailed market analysis for an in-depth explanation of these indicators and the effects they can have on the economy.
QUARTERLY MARKET ANALYSIS
Quarter one of 2019 was a smooth ride for many investors in domestic equities when compared to quarter four of 2018. From January 2nd, 2019 to March 25th, 2019, the S&P 500 had an arithmetic return of 11.49% and a standard deviation of only 6.13%. This is in comparison to quarter 4 where the S&P 500 had an arithmetic return of -13.97% and a standard deviation of 10.90%.
The two main questions investors should be asking themselves are,
why the sudden turnaround from the previous quarter and will it last?
The first quarter of 2019 was defined by low market volatility, high stock market returns, hopefulness on the US-China trade war, the Federal Reserve continuing the unloading of their balance sheet, a budget deficit record, lower credit spreads, and inversion of the yield curve. Our more astute readers might realize the previous group contains mixed signals and that some are grounded in the structural part of the economy and others are a derivative of that structure. The structural group that affects the real economy includes the US-China trade war, the Federal Reserve's balance sheet, and the inversion of the yield curve. The derivative metrics that have a causal relationship with the structural group include low market volatility, high stock market returns, lower long-term interest rates, and low credit spreads. In order to answer the forward-looking question of whether this low volatility and high stock market return environment will continue, we must examine the structural group.
In July of 2018, the United States slapped $250 billion worth of tariffs on various Chinese goods. Part of this was attributed to unfair trade practices and another part was attributed to the Chinese stealing intellectual property from the United States. The United States was threatening to add an additional 10% tariff on another $200 billion dollar worth of goods if trade talks went sour but as of late the hopefulness surrounding the talks have increased. Tariffs slow down the economy because they are a tax to the consumer, which means that it lowers the amount that peoples’ disposable income can buy. This inevitably leads to people either spending or consuming less. Neither of which are ideal for a growing economy. The tariffs have been one of the few things that have been a depressant on the economy since the tax cuts. However, if talks go well and they are removed it could give the markets a very strong tailwind in 2019. Investors would be smart to keep a close eye on how the negotiations progress.
The Federal Reserve's balance sheet and the yield curve is inextricably linked together because they both deal with liquidity in the economy. According the Federal Reserve Economic Data (FRED), as of May 2015, the Federal Reserve had $4.5 trillion of assets on their balance sheet which was unprecedented territory. This bloated balance sheet was the result of three rounds of quantitative easing which included buying toxic assets and flooding the economy with liquidity to keep the markets functioning through the ignition of nominal growth. While that magically worked, the Federal Reserve still has an unprecedented amount of assets on their balance sheet that they are attempting to unload. They are unloading their balance sheet by letting their assets mature instead of rolling them over like they have been doing since they bought the toxic assets. The main issue with the Federal Reserve unloading their balance sheet is that it is draining liquidity from the economy which is increasing the short term interest rate. Running parallel to this timeline is the increasing demand for the long term interest rate which is causing a depression of the rate. It is a conundrum for the Federal Reserve because they want to keep inflation around 2% and keep us at full employment (which we are currently at), but they don't want credit to be cheap forever because cheap credit leads to bubbles in the economy which almost inevitably pop in catastrophic ways (i.e. 2008).
Quantitative easing kept us from catastrophe but it resulted in the short term interest rate staying a effectively zero for years. Now that they are restricting credit again through quantitative tightening, the short term interest rate is rising. Market participants are pricing in quantitative tightening through buying longer term, less volatile, risk-free assets which is causing the long term interest rate to fall. This long term interest rate is inversely related to market perceptions of long term growth and inflation expectations of the economy. The rising short term yield and lower long term yield caused an inversion of the yield curve, which is one of the best predictors of an upcoming recession. The behavioral aspect of this process also causes a feedback loop which causes people to question if a recession is coming. This market anxiety can cause further inversion because this is a predictor of recessions and this feedback loop enforces the structural issues that an inverted yield curve causes.
A structural issue that arises out of inversion of the yield curve (specifically the 3-month yield and the 10-year yield) is that banks are less willing to lend because the spread between what they borrow at and what they lend at is less, or even negative. This means there is a multiplicative effect of money reduction in the economy between the Federal Reserve reducing liquidity and then banks reducing credit as well. This slow-down in credit and reduction in liquidity within the economy typically causes interest rates to rise along the shorter end of the yield curve which discounts financial assets and can cause a reduction in consumers’ marginal propensity to consume.
This overall slowdown in the velocity of money and liquidity causes net profit margins of companies to narrow which reduces profit margins unless they cut expenses. The largest expense to most businesses is labor which may cause part-time workers to have their hours reduced first, which causes a reduction in the weekly hours worked indicator. After that, if a business cannot reduce their fixed costs in other ways, it is likely they will begin to layoff workers which will cause unemployment to rise. Higher unemployment rates reduces consumers’ marginal propensity to consume even further which exacerbates the problem of falling profits. This snowball effect can cause natural recessions without any type of exogenous shock starting it. However, automatic stabilizers such as unemployment compensation help reduce the fluctuations in aggregate demand by helping to sustain consumption in periods of weakness. These automatic stabilizers, combined with counter-cyclical tax payments and a bigger share of the economy being in non-cyclical industries has historically helped to mute this natural snowball effect.
Fundamentals of the economy are extrapolated into the markets because they can change investors’ behavior of future expectations. These reactions can be played out in real time in the public markets. One of these real-time public market indicators is the credit spread which is inversely related to perceived credit riskiness in the economy. We measure the credit spread as the difference between a bond rated AAA versus a bond rated BAA. In quarter one, we saw a tightening of the credit spread which can translate to investors perceiving there being less credit risk within the economy. This metric is highly correlated with companies' profits because credit riskiness increases when profits decrease. Credit riskiness is an extremely sensitive metric and can change rapidly based on the market's perception. It is important to keep a close eye on it but narrow spreads could simply be the calm before the storm especially if other fundamental indicators that will change future corporate profits are changing for the worse.
Overall, the market return in quarter one was a positive result in comparison to the results of quarter four. Investing is inherently forward looking, and it is vital to avoid anchoring ourselves into where the market currently is and also avoid confirmation bias looking for reasons the market will continue on its historical bull market. There are a couple serious warning signs looming in the economy with the negative yield curve being the most glaring and the exacerbation of the trade war coming in second. On the bright side, the Federal Reserve decided to keep short term interest rates between 2.25% and 2.5% which means that if investors decide to go abandon their flight to safety with the 10-year yield then the yield curve has a serious chance of going back into a positive slope.
Focusing on the short term markets is important for tactical asset allocation but we believe strategic asset allocation is the most important for a long term investment strategy. Understanding the inherent long term risks within sectors, countries, and asset classes is vital. Compounding interest over a forty year period can cause vastly different wealth levels at retirement and understanding different long term risks in different investments can help you decide whether that extra 1% expected return is worth the risks.
Longer term issues that are currently ingrained within the domestic economy that aren't being addressed in the short term markets are the high levels of borrowing in the private sector and public sectors. February was a record month for a budget deficit at -$233.977 billion dollars and the government deficit is currently over $22 trillion and our net interest on our debt is over $350 billion annually. This deficit means that we currently owe over $180,000 per tax paying person in the economy. These high debt levels raise questions to the long term validity of domestic growth without high levels of leverage but in our opinion none of these are short term or even mid-term concerns for investors. They are simply numbers worth keeping an eye on for strategic asset allocation purposes over the long-term. These numbers also need to be taken into context on a global scale, as most developed nations have comparable debt ratios as the United States.
The United States is late in the business cycle and throughout the year it might be smart to diversify your assets into early to mid-cycle international growth markets, middle duration high quality fixed income, defensive sectors (utilities, consumer staples, and health care), and individual equities with sustainable economic moats. It may be prudent to lower exposure to domestic growth industries that are highly leveraged without sustainable profits, high yield fixed income (junk bonds), long dated fixed income, and cyclical sectors (information tech, energy, industrials, and real estate). Tactical asset allocation can potentially any portfolio weather systematic storms if done correctly. On the other hand, if done incorrectly, it could cause even more damage to a portfolio. This is why we believe tactical asset allocation should always be done within the context of strategic asset allocation and all of this under the umbrella of your specific financial goals.
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of The Lincoln Investment Companies. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.
The Federal Reserve System (also known informally as the Fed) is the central banking system of the United States and controls the Federal Funds Rate (aka Fed Rate), an important benchmark in financial markets used to influence the supply of money in the U.S. economy.
Standard deviation is a statistical measure of the range of performance in which the total returns of an investment will fall. When an investment has a high standard deviation, the range of performance is very wide, indicating that there is a greater potential for volatility.
Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth.
A recession is a significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP); although the National Bureau of Economic Research (NBER) does not necessarily need to see this occur to call a recession.
Federal Reserve Economic Data (FRED) is a database maintained by the Research division of the Federal Reserve Bank of St. Louis that has more than 500,000 economic time series from 87 sources.