Where are we in the current economic cycle? On the one hand, it seems like the economy has been growing for a long time, which it has. The current economic expansion is in its 96th month vs. the average length of expansions of 47 months since the year 1900, partly due to the growth in the service economy vs. manufacturing, which is less cyclical and more stable. However, the current expansion is also the weakest expansion in that same time period, averaging only 2.1% GDP growth since the start of the expansion, and this coming after the deepest crisis we’ve experienced in the post-war era. This weaker than average growth could be the result of lower investment due to excessive regulation or low productivity and labor force growth.
Although long and weak, elements that indicate continued expansion remain: the consumer has not greatly expanded its spending or debt, the housing market seems healthy with room to run, corporate investment is picking up. The economy doesn’t seem overextended like it might at an economic peak, but it is difficult to see a catalyst for >2% growth apart from tax and regulatory reform. For growth to accelerate, we also need more legal immigration to boost the growth of the working age population, which has lagged over the last decade.
At the June FOMC meeting, the Fed raised short term interest rates by a quarter of a percent, which was widely anticipated, the 3rd consecutive change and the 4th hike this cycle. While this pace is still relatively slow in historical context, it signals that the economy is strong and can handle a more normal level of interest rates. The two main factors that the Fed considers when it decides how to set interest rates are the unemployment rate and Inflation.
Although the employment data is somewhat skewed since many workers are “under-employed”, and a lower participation rate from baby-boomers retiring and some of the unemployed have given up looking for jobs, generally speaking, we are reaching full employment in our economy. The May data confirmed this, while also showing that not as many new jobs are being created. We still need to see more wage growth before rising inflation becomes a major concern. Inflation has been firming but recent measures have been notably weaker than expected. The Fed considers this to be temporary and that it will return to its target of 2% in 2018.
In addition to raising short term interest rates – another sign of confidence in the economy – the Fed outlined its plans to reduce its balance sheet holdings of Treasuries, beginning in September, and accelerating monthly. It will be interesting to see what affect this has on longer term interest rates. They should rise (and prices fall) as the Fed sells Treasuries, due to a larger supply of those securities being available. This year, longer term rates have remained stubbornly low even as short term rates have come up, due in large part to global quantitative easing.
When rates in other developed markets are sitting at or near zero, it makes U.S. Treasuries seem like a pretty good yield for the risk, so foreign demand for U.S. Treasuries is part of what has driven longer term rates lower. Recently, central bankers have signaled that the Eurozone economies are healthy enough to back off of the economic stimulus measures provided since 2014, and longer term Treasuries have sold off, sending yields up 10-12 basis points. If central bankers follow through at the same time the Fed begins to reduce its balance sheet, then we could a steep rise in 5-30yr Treasury yields.
Equity Market Summary
Eight years into this this bull market, the S&P 500 has soared by more than 200%. While most of the initial run was driven by earnings growth, valuations have also risen relative to earnings its long term historical average. Stocks usually do well in a gradually rising rate environment when rates are relatively low. While gains have been impressive and stocks are no longer cheap, they still look inexpensive relative to core fixed income.
Bear markets don’t just happen…external factors cause them. History shows that economic recessions, aggressive rate hikes, and oil price spikes have all been associated with bear markets. Today, it is hard to see any of these issues on the horizon.
An improving economy, coupled with re-emergence of profit growth last year, should provide support for equities. Corporate balance sheets, with large cash piles and manageable debt loads, also remain healthy and do not suggest that there are large issues looming in the corporate sector.
Emerging markets equities outpaced domestic U.S. equities, with the MSCI Emerging Markets index up 18.6% YTD. The S&P 500 index is up 9.34% YTD. Improving earnings and more reasonable valuations have driven the gains in international equities, adding to the prospect that there might be better returns abroad over the long haul.
LARGE CAPS OUTPERFORM SMALLER CAPS YTD:
GROWTH OUTPERFORMING VALUE YTD :
|Large Cap||13.99% vs. 4.66%|
|Mid Cap||11.4% vs. 5.18%|
|Small Cap||9.97% vs. 0.54%|
Best Performers: Year to date the Technology sector has been the best performing sector at 17.2% even with a 2% drop in the last week in June (which it has mostly rebounded from in early July). Healthcare has been the second strongest performer at 16.1% with the prospect of improved profits amid healthcare reform.
Worst Performers: Energy is the worst performing sector YTD at -12.6% with oil prices falling steeply over supply glut concerns from consistent growth in U.S. production. Telecom was the 2nd worst performer at -10.7% amidst its high dividend payout ratio as a proxy for income generation with the prospect of rising rates in the future.
Fixed Income Summary
The 10-year Treasury yield increased to 2.3% by the end of the quarter (6/30) from 2.2% at the end of May. This move reflects the Fed raising short term rates and the expectations of another rate hike before year end. The Federal Reserve also commented on the strength of the U.S. economy, which also contributed to rising rates.
Many analysts are watching the slope of the yield curve and how it has been flattening for some time as well as the implications for the U.S. economy. The Fed has raised short term rates while the long end (10 to 30 year) has not changed much, flattening the curve despite improving economic growth and inflation data. Although many recessions have come after a flattening yield curve, only half of flattening yield curves have been followed by recessions.
Fixed income investment performance had a solid second quarter with the Barclays Agg returning 1.45% and high yield returning over 2% (2.17%). Munis also returned nearly 2% (1.96%) for the quarter.
Year-to-Date Index Returns (as of 6/30)
|Barclays Euro Agg||7.54%|
|Barclays US High Yield||4.93%|
|Barclays Muni Agg||3.57%|