The Federal Reserve today reiterated it plans to continue what it has been doing and said it would continue to do, much to the chagrin of market participants.
While the last Fed minutes showed more dovishness, actual actions that are indeed ‘dovish’ have yet to occur. Reducing expected rate increases from 3 to 2 in 2019 was widely interpreted as, ‘the Fed might stop raising rates’, for some reason. History shows us that the Fed telegraphs well in advance what it intends to do. Thanks to Alan Greenspan, this has been the case for more than 20 years now.
What has the Fed said it will do in 2019? Raise rates two more times and continue to drain liquidity from the system via its bond roll-off program. It is also expected that other nations’ central banks will also cease adding liquidity this year. China may not have gotten the memo though, as they just lower their Reserve Requirement Ratio by 1%, freeing up approximately $100 billion in bank liquidity. This was announced on Friday, January 4, but was not even mentioned in the Saturday Wall Street Journal!
Here is a picture of global liquidity for 2019. From adding more than any given year in 2017, to net withdrawal in 2019. Adjust your expectations accordingly.
Dow Jones Industrials 3.95%/ 9.35% S&P 500 3.09%/9.34% MSCI Europe 7.37%/15.36%
Small Cap (Russell 2000) 2.46%/4.99% Emerging Mkts 6.27%/18.43% High Yld Bonds 1.37%/15.3%
US Aggregate Bond 1.45%/2.27% US Treasury 20+Yr 4.18%/5.66% DJ/UBS Commodity -3%/-5.26%
2017 and its second quarter continue to be kind to financial assets, with both stocks, bonds and gold all climbing year to date. European and Emerging Market equities have been the strongest this year, rising smartly after falling by 10% during the second half of 2016. Emerging Market equity funds are back to a price area that stretches back to 2009!
Bonds continue to vacillate in an upward trend since mid-December. The commodity index is down primarily due to oil, as agriculture and base metals are essentially flat on the year after a recent climb.
Correlations between stocks and bonds have increased recently, with equities being flat over the past 6 weeks as bond prices have declined over the last two weeks. While this phenomenon is negative for investors, equities appear to remain well inside their uptrend while bonds (and gold) appear to be near medium-term support levels. We may see both stocks, bonds, and gold again climb concurrently reflecting a continuation of the year to date behavior.
What has been driving stock prices? Growing earnings, low interest rates, lack of inflation, and ‘moderate’ GDP growth are the most common reasons to explain how prices have gotten to these levels. Earnings have been on the rise since the end of the ‘earnings recession’ that lasted from June 2014 through March 2016. After a decline of some 14% we’re now growing again, even robustly, given the low base from the previous year. Earnings are still one or two quarters away from hitting new all-time highs, yet the S&P500 is roughly 20% higher than in early 2015. The chart below gives us a visual of what prices rising faster than earnings looks like. Anytime the ratio is moving up indicates prices climbing faster than earnings.
By this metric (and there are many others) stocks are valued at a level only exceeded by the roaring ‘20s and the dot-com era. Can earnings continue to grow to support valuations? The continued lack of wage growth and continued generationally low labor participation rate are headwinds to growth in consumer spending. Consumer credit growth has slowed dramatically over the past six months and without wage or credit growth it’s difficult to see how the consumer will spend more to support ‘moderate’ GDP growth. Low interest rates, or the comparison of low rates to dividend and earnings yield have provided much support over the past several years to the reasoning behind bidding up stocks faster than their earnings growth.
Interest rates bottomed one year ago at 1.3% (10-year treasury) and then ran up to 2.6%, mid-range since 2010 and the upper range of rates since late 2013. The jury is out still on whether this marks the end of the bond bull market that has lasted since 1981. The problem is that if consumers and businesses must increase their interest expense, there is that much less left to expand their consumption and investment. Low rates had been a key enabler of more borrowing, leading to more consumption, and higher profits. Now, in some areas, analysts are saying that higher rates are ALSO good for stocks because it represents growth expectations. Frankly we’ve been ‘expecting’ growth now for several years, and the only positive representation of growth (GDP) we have seen is due to a willful under-reporting of inflation. Gains in expenses in housing, healthcare, and education have far outstripped the general inflation rate. At the same time, official statisticians tell us our TVs, cell phones, and other tech devices are far cheaper, because we ‘get more’ for our money. This is called hedonic adjustments. Look this up and you will understand why one’s personal experience with the cost of living doesn’t mesh with the official inflation statistics.
It seems the main reasons we are given for buoyant stock prices appear tapped out or stretched. The thing is, it’s been like this for a few years now. So then, what really is driving prices? Some of it has to do with FOMO, Fear Of Missing Out. No one wants to get left behind as prices rise, even if said prices already appear expensive. As fundamentals have deteriorated over the past few years what is causing or who could be that marginal buyer who always seems to have more money to put towards financial assets? Perhaps this chart has something to do with it.
As central banks have purchased outstanding bonds (and equities in the cases of Japan, Switzerland and Israel among others) the cash or liquidity provided has found its way back into the equity markets. Additional effects have been to put a bid under bonds, increasing prices and lowering rates. What many investors in the U.S. don’t realize is that the European and Japanese central banks continue to this day putting approximately $400 billion per month into the financial markets. If this is the true reason behind stock and bond price levels today, any cessation, slowing or even anticipation of slowing will likely have negative effects on asset prices. The chart below shows where the U.S. Fed ended its QE efforts while Japan and Europe picked up all the slack and then some. The astute observer can see where the Fed tapered, while the ECB was not adding liquidity, from 2014 to 2015. From mid-2014 to early 2016, the Vanguard FTSE Europe ETF dropped by 29%.
Beyond central bank liquidity creation there is also the concept of growth in the private sector. Here too we see that a phenomenal amount of debt must be created to sustain growth. New debt creation in China dwarfs the rest of the world. China has put up high growth numbers the past several years, more than 7% annually.
Going forward it will be crucial to watch for central banks’ behavior as to ending current ‘QE’ policies. Japan is still committed to a 0% 10yr bond rate, yet the ECB has begun to state that its bond buying won’t last forever, and is likely to slow by mid-2018. The U.S. Fed has indicated continued tightening via rate hikes (likely one more this year) and to begin to let ‘roll off’ maturing bonds. The roll-off will take liquidity from the markets. It will start small and gradually increase in 2019 and thereafter. These cessation tactics are done under the current understanding that financial conditions are ‘easy’. Put another way, the banks will start to slow new liquidity and then drain liquidity as long as financial conditions, which include stock market levels, don’t get to difficult. What exactly is the Fed’s downside tolerance is unknown. What is knowable, is that the decision-making process takes months to be put into effect and by that time, markets could move down and growth could halt.
Near Term vs Long Term
The concepts of credit creation and central bank balance sheets and their respective monetary policies are will have impacts on asset prices over the longer term. Year over year earnings growth forecasts, specific companies’ ‘beats’ or ‘misses’ and monthly data on inflation, job growth, and wages all have short term impacts on the stock market. Currently, earnings are expected to grow robustly, official inflation is subdued and official unemployment are all in the “very good” range. Combine that with the Fear Of Missing Out concept and that should help keep the markets up and even higher for a while longer. The problem is that simply because we want markets to move higher doesn’t mean they will. At some point paying 30x earnings will seem tooexpensive and the markets will lose some marginal buyers and some will become sellers, for whatever reason. Based on current valuation metrics and the business cycle, we know that equity returns over the next several years will be very low. If rates go up, and/or credit (the ability to pay) worsens for individuals and businesses bond funds will likely suffer as well. Over the long term, avoiding large losses or drawdowns, even while lagging the market on the upside, can have a dramatic positive impact over a full market cycle.
What Can Be Done
If one suspects returns will be lackluster, and prices volatile, should one endure it? The solution is at once simple and difficult at the same time given our cultural of equity ownership and the media’s constant focus on one asset class: equities.
Diversifying amongst the other 6 asset classes is a start. Most advice revolves around two classes, stocks and bonds. If one truly wants to buy low and sell high, one must identify the other areas that are “low”, increase exposure there, and reduce exposure to “high” asset classes. Not only does this smooth out volatility but can increase long term returns. Given the outlook for more volatility in stock and bond prices; very low prices (historically and relative to other assets) in precious metals, agriculture and oil; there should be many opportunities to take advantage of short term swings to benefit and move some ‘eggs’ from the equity side into other, non- and lower-correlated asset classes that are currently much lower in price.
Easier said than done, yes. This is exactly why investors should seek out Investment Advisors willing to do this difficult work and that have a strategy to deal with changing markets. For more information on how I am doing this for my clients, please contact me.
Adam Waszkowski, CFA
This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision. Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at firstname.lastname@example.org.