The Days Ahead: Jobs number on Friday. PMIs on Monday.
One-Minute Summary: No drama from the Fed. Rates and bonds barely moved. Most stock markets were lower with economic sensitive sectors like financials and materials down 4%. China and America agreed not to talk for the time being. The Mexico trade deal looks good and Canada may join up in the next few weeks. We're often asked why trade is not a bigger issue for the market. It is a big deal but nothing irreversible or financially catastrophic has happened yet. Frayed patience and tempers for sure. But we've not seen many large companies come out and say i) it’s a major problem and ii) we don't know what to do about it.
Another good quarter for U.S. equities. The rolling 1, 3, 5, and 10-year performance are all in double digits and the 10-year rolling return is now 11.5% compared to 10.1% at the end of the second quarter. That would turn a $100,000 investment into $293,000 and $261,000 respectively…a 12% improvement. Yes, time and small differences matter.
1. The Fed met and… Raised Fed Funds rate by 25bps to 2.25%. To no one’s surprise. Fed watching used to be a nuanced inspection of language. They meant to keep markets on the back foot. As Alan Greenspan famously said “I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I said.”
Things are very different now. The Fed embraced “forward guidance” some years ago, and now talks openly about what’s going on and what’s going to happen. That’s all fine. The only trouble is that it may delay policy changes (because they won't have communicated it) and give the Fed less room to maneuver. That's not a problem right now. But in the next few years, there’s going to be a time when what they say they're going to do and what they must do will be very different.
Here’s what we think was important:
Growth: revised up for 2018 and 2019. They now agree with the Administration that we’ll see 3% growth in 2018. But they also expect growth to peter out sometime in 2019. In other words, very different from the Administration. We'd certainly agree on that point. It’s difficult not to see the current growth spurt as merely bringing purchasing decisions forward by a quarter or two.
Unemployment: has bottomed out for this cycle. They don't see any further improvements
Inflation: coming in lower than they expected a few months ago
Rates: will top out at 3.5% in 2020, implying three more hikes in 2019 and two in 2020.
On the dot plots, we compared forecasts made in March and the latest one. Here it is:
It’s a bit hard to read (the Fed doesn't like graphic designers) but you can see i) the Fed Funds rate moving up by some 50bps more than they thought a few months ago and ii) more agreement among the Fed members. Back in March, the dots were more dispersed. Now they're clustered. The Fed Governors are singing from the same hymn sheet.
Two more interesting points. One, Fed policy is still accommodative, in our view, even if they removed the actual word.
The top lines show the Fed Funds rate and, in blue, the real Fed Funds rate (i.e. deflated by inflation). Anytime that's below zero, it’s an easy monetary policy. Two, the danger for the stock market is when tight policy starts to go easy, as in 2000 and 2008. We're a way off from that happening.
So bottom line? Good for equities and a smooth upward rise in rates. We’ve been advocates of the front end of the curve. The 2-Year Treasury yields 2.83%. You only get paid 13bps more for investing in 5 year and 22bps for 10 years.
2. How’s the Japanese stock market doing? Is something you need not have asked in the last 27 years. As readers know, Japanese stocks had a spectacular 1980s, peaked in 1990 and have been on cyclical ups and downs ever since. An investor putting money in at the top would still be nursing a 50% loss today.
Japan has faced demographic challenges. Its population peaked 12 years ago, its labor force 20 years ago and it has a labor force participation rate some 20% below the U.S. Things move slowly. But in recent years we've seen:
Real attempts at labor market and business reform
Very loose monetary policy, low rates and a weaker yen. The yen is a haven currency…tough to break the habits of flight investors
Rejuvenated business sector
Put those together with trade, ahem, talks, that mostly ignore or benefit Japanese companies, and we’re looking at a good outcome. Here’s the long term chart on Japan. In the short term, it tends to move with the yen: weak yen, strong market. And that's mostly what’s happened since 2013.
So far this year, Japan stocks are up 5% compared to the broad MSCI-EAFE market of -3%. It’s up 18% in local price and 8% to U.S. investors since the March lows. Japanese business is very competitive right now. It has become a major force in global M&A. Japanese companies have bought Shire (a major pharma company), Uber (through SoftBank), Irvine Scientific and Integrated Device Technology as well as our neighbor, Glassdoor. Japan’s small companies have done well…up 50% in the last two years and outperforming large caps by 18%. Small caps tend to reflect the domestic economy well. They're less dependent on the exchange rate.
Did we mention, things move slowly in Japan? This isn't one of those rush-in-now-and-buy stories. But it does reinforce our confidence in Asia ex the China is-all-that-matters, which has not worked well in recent months.
3. “We've fixed U.S. trade.” Possibly but it’s not showing up in the numbers. The revised Q2 GDP numbers came through. They were unchanged at 4.2% of which Net Exports contributed 1.2%. By comparison, they have not contributed more than 0.3% for more than six years. So the latest trade in goods number looks like this:
The deficit jumped from $72bn to $75bn, and way more than the $71bn consensus. This is enough to hold GDP back by 1% in Q3. The problem is that the tax cuts created demand which the U.S. cannot fill. No amount of tariffs will change that for the time being. Trade is set to look worse in coming months.
Bottom Line: Facebook and Tesla had a very bad week. In each case, it’s management not macro or business issues that did it for them. That’s a risk with some of the biggest tech stocks. Bonds will probably stay in narrow ranges for the next few weeks. Only a very bad employment number would upset the market.
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--Christian Thwaites, Brouwer & Janachowski, LLC
Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.
All charts from Factset unless otherwise noted.
Nick Drake - Northern Sky