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US Treasuries

100 Year of Inflation and Real Rates - Updated July, 2018

We looked at 100 years of inflation. This chart shows: 

1. The annual change in US inflation

2. The real rate of 10-Year Treasury bonds

3. The names and start dates of the Fed chairs

4. Highlights from each year that influenced inflation

Our takeaway is that inflation remains low by historical standards and that it has not been much of a problem for nearly 30 years. The level of real rates looks very low and suggests more deflationary than inflationary forces.  

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.

Tesla, Turkey, Treasuries.

The Days Ahead: Earnings mostly over. Productivity report

Listen to the Podcast: Apple Podcasts • Soundcloud • Google Play

One-Minute Summary: Strong week for equities with not much to change the tone of good results, modest inflation and economic numbers and a truce of sorts on the trade side.

Tesla said, “enough of this reporting nonsense, we’ll go private”. Then thought about it. Then couldn’t decide. Normally, we’d ignore stocks like these but the company has a record short position and there’s a lot of money at stake proving or disproving the Tesla dream. We raise it because, well, it’s just not good when i) CEOs announce market sensitive news by Tweet ii) there are convertible and iii) regular bond holders to consider and iv) there’s a very convoluted process for buying out shareholders that may just leave them shareholders, if they want. It’s just, you know, not good governance. And they're not the only ones. Call us old fashioned. Here and here have the best take on it and the SEC is on the case.

Berkshire Hathaway (BRK.B) had a good week. It reports on a Saturday to keep the news cycle at bay. One big change was that unrealized gains on the stock portfolio now report through the Income Account. This is a weird rule. Berkshire holds $50bn of Apple stock, which is around 10% of Berkshire’s market capitalization. If Apple goes up, Berkshire now has to recognize that through the income statement. So, in Q1 investments showed a loss of $7.8bn and in Q2, a profit of $5.9bn. You get volatility in return for transparency, I suppose. Some might like that. The core operating business did well and that was mostly what drove the stock up 5% for the week.

The 10-Year Treasury auction went well. As we wrote last week, this was a record amount of $26bn and we were concerned dealers would have trouble placing it all. But no, it was well bid.  But it adds to our concern that the yield curve will invert. Meanwhile, the TIPS curve inverted last week for the first time in 10 years. We should note that the yield curve inversion is not a sure recession indicator (see here) but more of a concern that growth will slow. Which we already know from other data.

1.     Is inflation out of control? No. But you may think so from some Friday headlines. The headline inflation hit 2.9% and the core inflation hit 2.4%. Here’s the chart with the blue bars getting all the headlines.

We expected these numbers mainly because there was a big base effect from 2017.

First, remember the cell phone expenses? They were falling at an annual rate of 20% a year ago. Well those deals are over.

Second, gas prices were flat a year ago but are now up 25%.

And third, used car prices are running high, probably as a legacy from the hurricanes when people needed to replace lost vehicles quickly.

These account for around 12% of the CPI. Take them out and we’re left with an inflation rate of around 1.5%.

Treasuries rallied by about 1%, so markets do not think any of this will change Fed policy. We'd agree. Meanwhile, real hourly earnings didn't change and average hours worked dropped. So, the outlook for personal consumption (the bit that's 70% of GDP), which was half the headline GDP rate of 4% in Q2, looks not so hot.

2.     How’s Turkey doing? Not well. Without diving into the dodgy politics and economics of Turkey…oh all right, Erdogan’s son-in-law runs the Ministry of Finance (here but they took down his bio) and promises to do something about the financial mess.  But it all came to a head on Friday as the Turkish lira dived. Here it is:

It's not often you see a 25% fall in a week for a sort-of major currency. The problems are fairly commonplace:

  1. over leveraged banks with
  2. mismatched FX
  3. 10% inflation and
  4. high government debt.

These are not good headlines but Turkey’s role in the world and Emerging Markets is small. Its economy is around $850bn and its stock market, down 50% this year, is around 1% of the Emerging Markets index. But even at that level, investors tend to hit the sell button on whenever there is a story like this. It's not enough to change our long-term thinking but adds to our short-term caution.

3.     Stocks at record high. Time to sell?  No. The S&P 500 is slightly below its all time high from January 26, 2018. But the better index is the S&P 500 Total Return. This one takes the 2% dividends from the S&P 500 and reinvests every quarter.

 And wow, what a difference that makes.

 Here's the chart with the S&P 500 on the bottom line and the total return on the top. One hundred dollars invested in the S&P 500 in 1989 is worth $1,070 today. With dividends reinvested, it's $2,066.

The total return index has had four all-time highs this year. The regular S&P 500 only one. That’s pretty normal and the only reason it’s not more widely reported is because, well, it’s kind of boring. “Remember to reinvest those dividends” doesn’t quite have the ring of “Why stocks will crash next week.”

So, dividends matter.

 Bottom Line: Earnings drove stocks to an all-time high. There’s little corporate news in the calendar so expect macro/tweets/trade to drive returns short term. Treasuries to remain strong because companies can expense pension contributions at the old higher corporate tax rate for another month.

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Other:

Best not to provoke bison

 --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.

Friday Music - Nils Lofgren

Stocks staying ahead despite trade

The Days Ahead: More corporate earnings. Industrial production.

One-Minute Summary: We’re in earnings season and it’s going to be a cracker. In most earnings seasons, companies “beat” expectations because that is how the game works. Analysts put out an estimate early in the season, the CEO (well actually normally the IR guy) sucks their teeth and says, “dunno about that…”, the analyst revises down (this can repeat a few times with knowing winks), and then the company comes in and beats. Everyone happy. That’s why 70% of companies beat every quarter. It’s not that CEOs are great or analysts incompetent. It's just how it’s played.

Anyway, if you're a CEO of an S&P 500, 400 or 600 company, you didn’t even have to show up in the first and second quarter and you would have a 10% to 15% gain in earnings just from the lower corporate taxes. But if you did show up and threw in some growth and buy-backs, then your earnings will be up 22% YOY this quarter.

So, we’re celebrating a great earnings season. But most of that was in the price of the S&P 500 seven months ago, which is why stocks haven’t moved much so far this year (although up 7% from the February mini-crash). Yes, small company stocks and growth had another good week.

There were good economic numbers as well. Job openings were strong, inflation moderate, producer inflation in control but the headlines were dominated by the latest round of tariffs, which now includes onions, buffalos and maleic acid (no idea, sorry) but not cell phones or computers. And of course NATO and BREXIT. Normally, when these stories dominate the fireworks are in FX markets and that was somewhat true last week. It seems as if markets are “What’d he jus’ say? He can't mean it. We hope he doesn't mean it. He doesn't mean it.” That cycle takes about two hours these days. Tailor made for neurotics.

Stocks were broadly higher here and in Europe but on summer trading, which always has a torpid feel. The 10-Year Treasury was flat but 30-Year Treasuries strong.

1.     The next recession. One of our favorite commentators over at Financial Intelligence asked this question recently.  One lore is that recessions do not die of old age; the Fed murders them.  Which is nonsense. Recessions are normally preceded by over leverage, inflation and crisis of confidence. The Fed is merely the instrument that starts the rate cycle.

 The Fed started hiking rates in 1972, 1976, 1986, 1993 and 2004, all without triggering a recession. And in some cases, as in 1973, 1984 and 1994 they started to lower rates some two years before a recession. And that points to another problem: insufficient data. Whenever you hear someone say “a recession always come when…” you can quietly muse that there have been eight recessions in the last 64 years (so 12% of the time) and 18 in the last 103 years. If a researcher from one of the hard sciences showed up with a theory based on 18 data points, you might politely sigh.

Anyway, here’s what we think might cause some problems:

  1. Politics and trade
  2. The fiscal stimulus from the 2017 tax changes running out sooner than expected
  3. High federal debt
  4. Corporate leverage

We don't really think the consumer is a problem this time round. Yes, things like student debt are off the charts and consumer and mortgage debt are at all-time highs in absolute terms. But so is GDP and we’re fine with personal debt growing in line with nominal income. Consumer and mortgage debt is now around 70% of GDP from a 2009 peak of over 90%. Also, we’ll stick to our belief that the forces causing the recession last time don't get to do it again. So, the consumer gets a pass this time round.

Corporate debt is a different story. Here it is:

This shows corporate bonds owed by non-financial companies (blue bars) doubling from 2008. But they've also increased cash so the net borrowing is around $4.5 trillion. That reached a record level of over 20% of GDP two years ago and has since plateaued (bottom graph).

We've excluded other corporate debt, like bank loans and payables. We'd add that not all these companies are financially stretched. Still, it’s a high number and at some point, rising rates, if only at the short end, are going to make life difficult for companies. That’s why we've been lightening up on corporate credit for the last few months.

2.     What's inflation up to? Not much. Last week’s report showed headline inflation at 2.8% and core (so knock out food and energy) at 2.2%. This is above the Fed’s goal but i) the Fed uses the broader PCE measure of inflation and that’s at 1.9% and ii) there are some important base effects going on, that we've written about. The main one is cell phone rates, which fell sharply last year when Verizon cut prices, and used cars, but both are pretty much done. The Fed’s, rather difficult, job is to differentiate between temporary and entrenched inflation.

The Atlanta Fed tries to do this with its Sticky and Flexible measures of inflation. Sticky prices are ones that don't change too much. The classic example is coin-operated laundries, which change their prices once every six years. The list also includes fees, rent and medical costs. Flexible prices are those that change a lot. So things like vegetables, gas and clothes change prices every few weeks. This is what’s going on with the two:

As you would expect, Flexible prices are volatile with prices swinging from -3.0% to 3.5% in the last year. Sticky prices are moving much more slowly and haven’t changed their rate of growth much in the last four years. We think it's likely to stay that way. And as for wages?

They're not keeping up with inflation (black line). To some, this is a puzzle. Low unemployment, low participation and a tax change trumpeted as good for workers and their wages should lead to wage increases. But, no. There has been some increase in hours worked, so take-home pay is up. But it's by a very small amount. For us, real wages have to increase to push inflation up meaningfully and, so far, ‘aint ‘appening.

Bottom Line: More good earnings numbers coming up. Stocks are within a whisper of all time highs but, if companies report concerns about tariffs, expect some weakness. We still favor small company stocks

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

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SEC drops whistleblower prog

Young billionaires

 --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.

Detectorists

Vacation Week Trading

The Days Ahead: Corporate earnings kick off. It’s going to be another strong quarter.  

One-Minute Summary: U.S. Treasuries had a good week with the 10-Year Treasury at 2.82% and the 30-Year Treasury well under 3.0%. The gap between the two is now 11bps, the lowest in 11 years. Stocks had a good week and we’re now in positive territory for the S&P 500 year to date with small company and tech stocks way ahead…up over 11% in both cases. International markets recovered but Emerging Markets again struggled.

On the one hand, yes, the trade issues continued but markets have had plenty of time to adjust to the threats so nothing really new. On the other, international markets stand to lose more from trade so will take longer to adjust. Things got a little better when a story went round that Trump’s Ambassador to Germany offered zero tariffs on all auto trades. Could happen. And on the other (see what we did there), the dollar weakened and bonds rallied on an employment report that showed no increase in wages and more people looking for work. That would seem to shut the door on the whole wage inflation, labor shortage argument.

We'd remind readers that summer trading can be very thin and misleading. The short holiday week and a heat wave on the East Coast meant volumes were light. Markets can and will overreact to news. And as we say, “prices move faster than fundamentals… don't confuse the two” (h/t David Ader)

1.     "Trade wars are easy to win". You might say to yourself, if you measure the country’s trade deficit since the phony trade war started in January and moved into a more serious phase a few months ago. And if you were into charts, you would point at this and say, let’s Make American Exports Great Again.

Because of the way the BEA calculates GDP, the improvement from January to May would account for about a 0.7% improvement in GDP. Pretty good work. What shall we solve next?

But this month’s trade figures give us the excuse to bring out one of our favorite charts: U.S. soybean exports. And here they are:

The U.S. is a big exporter of food. Around $150bn a year out of $1,400bn in total goods exports. The U.S. sells a lot of soybeans, corn and meat products and imports wine, fish and fruits and vegetables. They tend to balance each other out. But one big export earner is soybeans. And they all go to China. The green line shows the trend. They rocketed from $2bn to over $4bn. That’s a very big change on an annualized basis, which is how GDP will measure it.

They have spiked before, notably in 2016 when there was a poor harvest in Brazil. But this increase is even bigger and there’s no mystery why. Chinese importers were buying ahead of the tariffs imposed today, which were in retaliation to the $34bn of Chinese goods targeted by the Administration. We certainly don't expect these numbers to improve in coming months.

So, the headline looks good for now and will help the Q2 GDP numbers for sure. But by the middle of Q3 the deficit will start to worsen.

Look, we know U.S. trade is a mess right now. Companies don't know whether to change suppliers, move overseas, expand or prepare for price increases. The ISM data on manufacturers’ prices paid has risen for 28 straight months and is by far the highest indicator in the dozen metrics tracked by the ISM. Trade talk is going to continue to dominate capital markets for the rest of the summer. We think that eventually businesses, politicians and consumers are going to protest at higher prices and the overall disruption. But it’s only the last constituent that counts for this Administration. And they have yet to feel the pressure.

2.     Are bonds good value? We'll preface this timeless question with the normal “it depends.” But by one measure, yes. We looked at the yield on the S&P 500 and compared it to the 10-Year Treasury. Here’s the chart:

The black line is the 10-Year Treasury yield at 2.84%. The blue line is the yield on the S&P 500 at 2.04%. When equities yield more than bonds (which is not often), they tend to be very good times to buy stocks. When bonds yield 200bps more than equities, it tends to be a good time to buy bonds. We're not there yet. It’s only around 80bps. But here’s the point. Stocks these days don't offer a great dividend payout. Some 100 of the S&P 500 don't even pay a dividend. Many would rather use buybacks to boost share prices because they're more tax efficient and tied to executive pay (color me skeptical, I know).

So, bonds at around 3%, which they were a few months ago, seem very fair value against stocks. We've seen a lot of the bond bears reverse position in recent months. Some of that is shorts caught out but some is down to bonds, especially Treasuries, just representing good value right now. As clients know, we've been investing in the mid-part of the Treasury yield curve for some months now and we’re inclined to remain there.

 Bottom Line: Good earnings numbers coming up but export traders (BA, CAT etc) will remain under a cloud. Large cap will probably remain in the 2600 to 2800 trading range. It closed 2750 on Friday.  Emerging Markets remain the weak point.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Drone over Tesla, Fremont

 --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.
Friday on my Mind
 

Small Caps deal with rising rates

The Days Ahead: Fed minutes but otherwise a quiet week.

One Minute Summary There is one stock index at a record high. Take a bow, U.S. Small Cap stocks, which are up 6% this year and climbed over their January 24th record high. We actually prefer the S&P 600 as a small cap index, for reasons we explained here.  That has also hit an all-time high and is up 7%, mostly because it excludes speculative, blowout companies that don't make money. Why the small cap love-in? Well, put most of it down to recent dollar strength. Small companies don't have the same overseas exposure of the S&P 500 large cap so are less affected by a strong dollar.

Stocks had a sideways week. We kind of expected that because economic news has been fair to middling and the trade stuff is very much in the background. Total containers moving from the Port of Long Beach jumped 16% in April. We think that’s down to exporters and importers trying to get ahead of the announced trade restrictions from March 1.

Housing, retail sales and industrial production all came out. They were steady, not spectacular. We think we've reached the peak in housing for this cycle. It’s at 1.26m compared to the pre-recession record of over 2m. Higher mortgage rates will keep housing demand flat for a while.

European markets struggled mostly with the news from Italy. Italian stocks had been one of the best performers but investors sent bond yields up by 40bp in less than two weeks. It’s all down to politics. U.S. bond yield also climbed. The economic news seems to confirm the Fed outlook. Steady growth and interest rate hikes.

1.     How are the tax cuts going?  Well, one area you’d expect to thunder ahead would be retail sales. Lower taxes, more take-home pay, more discretionary income, stable inflation, more confidence. Personal consumption is 68% of the $19.9 trillion U.S. economy. Knock out some essentials like food, housing and health care and there is around $7.5 trillion of spending. We were waiting for the April numbers because the tax refunds were done, the new withholding sorted and the distortions caused by the hurricanes (where people bought forward purchases of furnishings and autos) were over.

Surely the new confidence was at hand? Last month’s retail sales (blue column) were up 4.6% YOY, which was down on the prior month but marginally better than the start of the year. We also took a look at what people spend on necessities.

That number was also up 4.6%. What stood out was the 12% increase in spending at gasoline stores (the lower chart). Now, we know, not all sales at gasoline stores are of gasoline but neither are they big-ticket sales reflecting solid confidence. Our read is that basic household items absorb much of the increase and that discretionary spending remains weak.

We're in the minority in thinking these retail sales were pretty meager. The Atlanta GDP Now model raised its estimates for Q2 growth and the 10-Year Treasury bond yield rose 8bp to 3.08%. We're going with around 3% GDP in Q2, less than most. But there is still half the quarter to go.

2.     Does the run up in bond yields change our outlook? No. We fully expected three hikes from the Fed this year. It may even be four. So, two or three to go. Our view on rates is built on inflation, growth and credit demand.

We also look at simple break-evens that measure how much yields would have to rise in a year to lead to an annual return of zero. Low yield and high duration numbers (which we had in January) mean lower break-evens and vice versa. An example is the current on-the-run (i.e most recently issued) 10-Year Treasury, which has a yield to maturity of 3.01% and duration of 8.41 years. The break-even is 3.01/8.41 = 36bp. So the 10-Year note yield would have to rise to 3.37% for the bond to return zero over the next 12 months.

The shorter the maturity the lower the duration. So a 2-Year Treasury yielding 2.55% with a 1.9 year duration has a break-even of 134bps. At the other end, a 30-Year Treasury at 3.13% and 19.19 years is only 16bp.

There’s always a risk of continued curve flattening (where there is not much difference between 2-Year and 10-Year rates) as this shows.

In an expanding economy the difference between a two and 10-year rate is more like 200bp, not the 49bp we see now. A flattening yield curve would mean long term bonds don't change much as front-end yields rise.

So what? Well this all means that we prefer the short to medium end of the curve, at the 7-10 year maturity or six-year duration. The break-evens are higher and the risk/reward looks attractive.  And that’s where we've positioned most of our bond portfolio.

3.     Women in the workforce. We talk a lot around here about demographics and the economy. One sure thing about demography is that you kind of know what’s going to happen. Today’s twenty somethings will, in 20 years a) still be alive and b) buying life insurance, savings products and sensible stuff. It gives you some idea of the overall direction of the economy. But one data item that really strikes us is this:

The top section shows labor force participation by sex in the U.S. The female work force has declined pretty drastically since the recession after years of climbing up. Japan is on the lower chart. That upward slope on women working is impressive. Japan has a real demographic problem. Its population has declined and the average age has crept up. Nearly 30% of the population is over 65. The government has put a lot of effort into attracting women into the workforce. And it’s working. We like where Japan is going for a number of investment reasons and this week’s slip in GDP does not overly concern us. The increase of labor participation seems a very good forward indicator.

Bottom Line: We'll be looking at news from Europe. Growth has stalled but we think it’s temporary. Next week will tell us more.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Stealing owls

--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.

 

 

Tech saves the day

The Days Ahead: Inflation number and the tail end of earnings.  

One Minute Summary A run of not-so-great economic news but there were good reasons for most of them. The trade deficit narrowed a bit, which lends support to the arguments that lower import demand would follow from the unusually high levels after the hurricanes last fall. The ISM Manufacturing and non-Manufacturing indexes both fell and, worryingly, in the employment sections of the reports. It just seems that employers are very unwilling to start hiring in big numbers. The core (PCE) inflation numbers inched towards 2.0% but there’s a big base effect going on from low hospital services (now up 7%) and energy prices (now up 8%) this time last year.

The Fed met and acknowledged slightly higher inflation but slower growth. There was no press meeting but we feel they must be twitchy about trade tensions and some slower growth in the world economy. We'll know more the next time they hold a press conference in mid-June. We feel the Fed will be fine with a few months of the core PCE at 2% and will wait until late summer for any signs of lasting inflation. We think inflation will remain low, which is why we like bonds at these levels.

Stocks were mixed but had a big Friday. Apple had a monster week announcing another $100bn share repurchase and a 16% increase in the dividend. It rose 12% in the week and it's now worth $900bn. U.S. stocks are up 1.6% this year but there’s no momentum or theme. Nearly all U.S. and foreign markets are around plus or minus 1.5% so far. The only outlier is China, which is trying to solve some of its own trade issues.

1.     How about those new jobs?  Not as well as expected. Non-farm payrolls came in at 164,000. Most people were expecting closer to 200,000. But the prior month was revised up. Here’s the chart: 

We're less focused on the absolute numbers these days and more on the hourly earnings and labor force participation. Why? Well, the reported unemployment numbers are about as low as they can go but that alone doesn't mean there is full employment or wage pressure just around the corner. Hourly earnings rose 2.6% (the lower line in the above chart). Given that non-core inflation is only just below that, it means real earnings are flat. And average weekly hours worked was unchanged. Participation slipped a bit.

All in all, nothing for markets to run on in any direction.

2.     Are U.S. stocks expensive? About 6% less than they were a few months ago. What we've had is a run of very strong earnings. The blended earnings growth in Q1 was 24% and that's the highest since 2013. The energy sector grew earnings by 93%. They're still important to the economy at 6% of the S&P 500 but with 10% and 8% of the S&P 500’s sales and earnings.

Here’s an important chart we look at:

It shows the earnings yield of the S&P 500 at 6.3%. We then reduce that number by the level of inflation. The higher that lower black line, the cheaper the stock market relative to inflation and bonds. Right now it’s cheaper than it was for most of 2017 but not as cheap as it was in the 2012-2015 period.

No one stock market measure is infallible, of course, more’s the pity. But we think the market is adjusting to the gradual rate rise as well as the less than stellar global macro news.

3.     How’s the Treasury doing? Meh. So, every year the Treasury tells the markets how much it’s going to borrow. The amount is basically refinancing of maturing debt and raising of new debt. Early estimates are for $950bn in 2018.

This should be fairly straightforward except the forecasts of what the budget deficit varies by who’s doing the talking. A few weeks ago, we highlighted the CBO’s estimates and they had a chart showing the deficit like this:

But the Treasury recently put out deficit estimates and their graph looks like this:

They both agree the number was about 3.5% for 2017 but then, you know, they kind of take different roads. Basically, the Treasury says growth will rip along at 3% and more and raise lots of tax revenues with no recession and the CBO says, er, probably not. The CBO is a pretty independent, bi-partisan and objective body. Steven Mnuchin runs the U.S. Treasury.

So we’re dealing with a bit of a movable number here and the markets were surprised when the Treasury announced they would only borrow $75bn in Q2 compared to an estimate of $176bn a few months ago and $488bn borrowed in Q1. So that was a bad day for Treasury bears and the 10-Year Treasury rallied some 10bp (or up 1.5% in price).

Does this mean tax receipts are in great shape and the deficit okay? No. The Treasury prefunded some of its needs and April brings in a lot of tax payments, so we don't get to sound the all clear. It demonstrates the seasonality of Treasury bonds (and therefore the bond market). They tend to be weak in the first quarter of the year. Why?

  1. Inflation tends to come early in the year. If businesses raise prices, they’ll get it done as soon as they can.
  2. Japanese investors repatriate dollars by selling Treasuries ahead of the end of the fiscal year in March.
  3. High refunding needs ahead of tax deadlines (h/t David Ader, IFI Research).

Anyway, with all this, we would expect the 10-Year Treasury to stay well below 3% in the near term, despite the expected Fed hiking in June. So, we’re okay with the level and sentiment in the bond market right now.

Bottom Line: We don't expect any break out from the range bound market we've had for three months. We'd be worried about another round of big and leveraged M&A activity (looking at you T-Mobile/Sprint). That tends to typify late cycle activity.  We'll probably look to reduce portfolio volatility again soon.

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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.

 

2018 Outlook.

A year to remember.

We sent this to clients recently, so if you're a client, you can skip this. 

It was a most extraordinary year. It started fearful and ended exhausted but exuberant. In January, stocks were in a “show me” mode. The brief post-election rally fizzled, bonds tracked sideways and only the dollar was showing any sign of weakness. But markets then took a calmer look. The givens were that the Fed was going to move slowly and announce clearly. No surprises and no drama. It was the opposite in Washington but markets seemed to distinguish bluster from threat. And anyway, one consistent motif was that government was going to go light on business regulation, cut taxes and spend on infrastructure. In the end they delivered on two out of three, although we’d be the first to agree, it was a messy process.

Overall, we’d point to three main themes:

1.     Supportive Monetary Policy: From March on, we had only minimal and short-lived corrections. For the year, the S&P 500 was up 22%, international markets +25%, long and short-term Treasuries +7% and 1% respectively and Emerging Markets +38%. From mid-year on markets never looked back. It was also a year when there was a noted absence of volatility. We were not surprised. Volatility in the past was often the result of the Fed playing its cards close and keeping markets in suspense. This time, the major central banks led by the Fed but closely followed by the European Central Bank and Bank of Japan, flagged their intentions loud and clear. Meanwhile, we saw steady and synchronized growth across the world.

2.     Corporate Profits recovery: But perhaps the most important feature of 2017 was that companies delivered on growth. For some years, we’ve seen U.S. companies produce decent earnings growth through a combination of share buy backs and financial and tax management. This was fine as far as it went but the fashion for big buy backs was on the wane going into 2017. Investors wanted real growth and they got it in 2017. We saw corporate earnings for the S&P 500 grow around 10%. All sectors participated including energy and commodity stocks, both of which had a tough couple of years. Only one industry sector had a negative return: telecomm, which found itself in the middle of a price war.

3.     Global Growth: Europe finally started to perform as the monetary easing fed through to the real economy. Two major elections in Germany and France returned centrist, pro-growth governments. Japanese stocks had a very strong year, up 19% (but up 23% to a U.S. investor). Why? A successful reelection by a popular Prime Minister, pro-inflation policies and a pick up in world trade.

So what’s ahead for 2018? As we write this in the first week of trading in the New Year, we’ve seen all major markets run ahead. Some of that is a reaction to the tax changes rushed through in the last days of 2017. Although the plan runs to 400 pages, its central tenet is lower corporate taxes. For many companies, especially if they are more domestic than multinational, the 15% tax decrease falls straight to the bottom line. Companies will start to talk more about the effects of a lower tax in the upcoming earnings season. But for most, there will be very little downside to the changes.

Elsewhere, this is what we see running in 2018.

1.     World Economy upswing. Global growth is moving along at 4% or so, up from 3.5% in 2017. The sheer size of the U.S. economy, some 25% of the world economy, looks like it will break through the 2% growth pattern we've seen for years and could grow at 2.5%. In the last three quarters of 2017, growth exceeded 3% but that may be unsustainable given recent trade numbers.

Emerging Market economies should have a strong year. China will grow at around 6% but more important, Russia and Brazil will recover from years of low energy prices and consumption. Japan will remain a huge beneficiary of global growth and we expect higher inflation and wage growth to support the domestic side of the economy. The EU is still early in its growth cycle. Many European multi-nationals will benefit from U.S. tax reform and corporate margins and profitability remain well below their 2007 peak. Plenty of room for upside.

2.     Interest Rates. The Fed will raise rates. The unemployment rate will remain around 4% and most of the Fed believes that a tight labor market means higher wages and prices. Of course, neither of the last two has happened and we don't expect them to. But the FOMC is more hawkish in 2018 than 2017 and several seats remain unfilled. So expect two to three rate increases this year. But, two important points:

1.     When interest rates rise, equity declines are rare. In other words, higher rates mean a better economy, which is good for stocks.

2.     If rates increase gradually, which is what we think will happen, bond markets and prices adjust. And total returns will remain positive.

We also believe rates will remain low globally. Other major central banks are three years behind the Fed in tightening. We expect German and Japanese long bonds to remain well under 1%.

3.     Equities will outperform bonds.  This may not sound like a high hurdle but equities here and overseas remain attractive compared to bonds. International markets are cheaper than the U.S. (even after adjusting for different industry weightings) and companies are still generating strong cash flow and paying and increasing dividends. We would look for an 8% improvement in U.S. stocks and stronger numbers overseas.

Some portfolio changes. We reduced our allocation to Treasury Inflation Protected Securities or TIPS and reinvested into longer-term U.S. Treasuries. We also will continue to take some profits on U.S. REITs, and allocate money to Asia-Pacific markets and international small cap.

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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.