Investment Review and Outlook March 31, 2019 FIRST QUARTER REVIEW
Reduction in Fear
Over the last three months of 2018, the markets reacted to the increasing concerns raised over:
Escalating trade tensions between the US and China and the possibility of a “trade war.” Comments made by Federal Reserve Chairman, Jay Powell, indicating interest rates would be raised materially higher – to a level many feared would choke-off economic growth. The potential consequences of the release of Special Counsel Mueller’s report, as indications grew that his investigation was nearing its completion.
Each of those fears subsided in the first quarter of 2019:
The US and China progressed with negotiations. Threatened higher tariffs were postponed. The Federal Reserve formally voted not to raise interest rates any time soon and provided reassuring comments. The release of the Special Counsel’s report contained no further indictments nor findings of criminal intent.
2 FIRST QUARTER REVIEW
Capital Markets Returns
In the first quarter, the markets responded to the falling risks, in almost mirror-like fashion from the fourth quarter:
Asset Class Quarterly Returns
Q4 2018 Q1 2019
Emerging Market Stocks Foreign Developed Market Stocks Energy Pipeline MLPs US Small Cap Stocks Commodities Hedge Funds Real Estate (REITs) US Large Cap Stocks Treasury Inflation Protected Securities Gold - Up in Q4 and Q1 US Bonds - Up in Q4 and Q1
-20% -15% -10% -5% 0% 5% 10% 15% 20%
3 OUTLOOK
Unusual Current Economic Expansion
The US economy is likely to reach the longest period of expansion on record.
Can it last?
Length of Economic Expansions in the US
Recession of 1949
Recession of 1953
Recession of 1958
Recession of 1960-61
Recession of 1969-70
1973-1975 Recession
1980 Recession
Recession of 1981-82
Beginning Expansion of Beginning Early 1990s Recession
Early 2000s Recession
2008/09 Recession
0 20 40 60 80 100 120 140 Months
4 Source: US Bureau of Economic Analysis OUTLOOK
Will the Expansion Continue?
The current economic recovery is different in that growth has been unusually slow, but steady (see below).
Its slow and steady nature may explain why fewer imbalances have surfaced than is typically the case this far into a recovery.
5 Source: Goldman Sachs OUTLOOK
Will the Expansion Continue?
Historically, accelerating inflation is a telltale warning signal of a coming recession.
Inflation continues to remain subdued and has decelerated most recently.
US Inflation Rate (CPI) Recession US Inflation Rate (CPI) 15%
12%
9%
6%
3%
0% 1948 1950 1952 1954 1956 1958 1960 1962 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2012 2014 2018 1964 1966 1988 2010 2016 -3%
6 Source: FRED OUTLOOK
Will the Expansion Continue?
Historically, accelerating spending on assets by businesses and households (“Private Nonresidential Fixed Investment”) has also been a warning sign.
In this recovery, spending on assets has been, and continues to be, modest.
Yearly Rate of Change in Real Private Nonresidential Fixed Investment
7 Source: US Bureau of Economic Analysis OUTLOOK
Will the Expansion Continue?
Residential real estate investment typically rises in the lead-up to recessions.
Even after rebounding strongly, spending on residential real estate remains quite low.
8 Source: FRED OUTLOOK
Will the Expansion Continue?
Rising debt has often portended recessions – most evidently obvious with the jump in mortgage debt in the lead-up to the 2008-2009 financial crisis.
Since the initial increase in government debt in the immediate aftermath of the housing crisis, other than a measured rise in corporate debt, the increase in total issuances has been mild.
Private Sector Debt Issued
Billions Mortgage Debt Corporate Debt Asset-Backed $4,000 $3,500 $3,000 $2,500 Billions Total Debt Issued $2,000 $8,000 $1,500 $1,000 $7,000
$500 $6,000 $0 $5,000 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 $4,000
$3,000 Government Debt Issued $2,000 Billions Municipal Federal Agency Securities Federal Government $4,500 $1,000 $4,000 $3,500 $0 $3,000
$2,500 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 $2,000 $1,500 $1,000 $500 $0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
9 Source: SIFMA OUTLOOK
Will the Expansion Continue?
Historically, rising short term interest rates have preceded recessions.
Short term borrowing costs have increased but remain quite low and are not projected to increase materially this year.
Short Term Borrowing Cost Recession Federal Funds Rate 18%
16%
14%
12%
10% Projected by January 2020 8%
6%
4%
2%
0% 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
10 Source: FRED, CME OUTLOOK
Will the Expansion Continue?
“Be fearful when others are greedy and greedy when others are fearful.”
Excessive optimism is typically borne-out in one of two ways, but is not evident today:
1) High amounts of flows into stocks – Compared to the last five years, the amount of money going into stocks is low over the last 12 months, 3 months and last month.
11 Source: Vanguard OUTLOOK
Will the Expansion Continue?
2) Overvaluation – Based on history, that does not appear to be the case today. At current levels of inflation, valuation has historically been higher.
Historic During periods when The average S&P 500 USA inflation was: P/E Ratio was: Inflation P/E Ratio Less Than 2.5% 19.3 1.9% 17.0 2.5% - 3.5% 19.7 Emerging Markets Inflation P/E Ratio 3.5% - 4.5% 16.1
4.2% 13.1 4.5% - 5.5% 15.3
5.5% - 6.5% 13.9
6.5% - 7.5% 9.6
Greater Than 7.5% 8.8
12 Source: Goldman Sachs. For the period 1950 – 2018. 12 month forward earnings RISKS
Risks
Each economic cycle is different; rarely are excesses repeated. Potential risks to the economic cycle include:
Employment Costs – An acceleration in wage growth would likely crimp corporate profits and lead to rising inflation. Despite low unemployment and a high number of job postings, wage growth has been and remains remarkably modest, but bears watching.
13 RISKS
Risks
Corporate Earnings Trends – After rising consistently for four years, expectations for corporate profits have fallen. They appear to be stabilizing, but the upward trend was clearly broken.
14 RISKS
Risks
Political / Policy
• China trade negotiations – At this stage, anything short of a substantive agreement would be viewed as a negative surprise.
• Brexit – England’s future relationship with the European Union is completely uncharted. If a break occurs without an agreed upon set of conditions (a “hard exit”), then the tentacles of disruption could be far-reaching in an already slow-growth global environment.
• Policy shifts toward wealth equality and away from growth – Rhetoric is always present, but hard examples of backlash include the cancellation of Amazon’s New York operation and the passage of a surtax on real estate transactions above $2 million, also in New York, are real.
15 CONCLUSIONS
Conclusions
Typically in the past, as expansions went on, imbalances in the form of shortages or excesses developed, ultimately leading to recessions.
Despite the unusually long duration of the current economic expansion, no clear signs of imbalances have yet developed, probably at least in part due to the low, steady rate of growth throughout the recovery.
Valuations on stocks are reasonable in the absence of a recession. At the same time, the probability of a recession rises at some point, as does the downside risk for stocks.
Therefore, even with a low probability of a recession, the risk versus reward of stocks is skewed somewhat toward negative. For that reason, portfolios remain invested slightly at the conservative end of target ranges.
16 CONTACT INFORMATION
www.ChathamCapitalGroup.com
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