“The economy, stupid”
-James Carville, 1992 presidential campaign
In June President Trump tweeted, “In many ways this is the greatest economy in the HISTORY of America….” Hyperbole aside, the US economy has been strong. For the 2nd quarter, GDP growth registered 4.2%, the strongest rate of growth in almost four years.
Fiscal stimulus measures (tax cuts and regulatory reforms) have spurred economic growth. Retail sales are at all-time highs. Unemployment claims have declined to multi-decade lows. Corporate earnings have been strong. All’s good, right?
It’s always useful to look to the bond market for a “grown-up” confirmation of economic forecasts. Prices of longer-dated bonds show no signs of an overheating economy. To the contrary, the yield curve – a graphical representation of yields across various maturities – has flattened, implying low expectations for future economic growth and inflation.
Normally, the yield curve is upward sloping, with short-term bonds yielding less than long-term bonds. (This makes sense as one would expect to be compensated with higher yields for tying up their money in longer-dated bonds.) Since the Federal Reserve changed course in 2016 and began “monetary tightening” by hiking the short-term Fed Funds rate, the 1-mos US Treasury Bill yield has increased from 0% to 2%. However, over the same period, the yield of the 30-year US Treasury Bond has hovered in a narrow band around 3%. Today, the difference in yields between 2-yr and 30-yr US Treasury Bonds is only 40 basis points, or .4%!
The “2s10s Spread” measures the yield spread between 2-yr and 10-yr US Treasury Bonds. The 2s10s Spread is often used to measure the slope of the yield curve. Today, the 2s10s Spread is only 26 basis points. One or two more Fed Funds hikes and the yield curve would expectedly invert.
The 2s10s Spread is also used as a recession forecasting tool. Below is a 2s10s Spread chart. Notably, every US recession (grey, vertical bar) in the past 60 years has been preceded by a yield curve inversion. Note: We are not calling for a recession. Nor are we pointing to an inversion as a foolproof harbinger of recession. But we are aware of the phenomenon.
Internationally, the economic picture is not so rosy. The EURO Area, for example, registered economic growth of only 0.4% last quarter. Emerging markets, especially those that rely on US Dollar-denominated debt, have been hurt by a rising US Dollar and the ramifications of escalating “trade war” tensions between the US and China. This has led to declarations of a “decoupling” between the US and the rest of the world.
With a global economy more interconnected than ever, decoupling doesn’t ring true to us. Instead, there is a distinct possibility that there currently exists a “lead-lag” relationship between the two. If so, the question to ask is, “who is leading whom?”
Markets have clearly bifurcated. Relative to international equity markets and other asset classes, the US stock market has been the only real winner this year. Developed international stock indices are negative. Many emerging markets are down double-digit. High-quality bonds are down. Most alternative investment categories, including commodities, are down. Diversification has hurt, not helped, performance this year.
Why diversify at all? We’ll spare you the academic support as well as the explanation of fiduciary responsibilities. Suffice it to say, diversification works, and diversification is prudent. And prudence is only trumped by hindsight.
The bulk of the gains in recent US stock index performance can be attributable to a handful of large-cap technology (growth) names. One group, in particular, is the “FANGS” which is comprised of Facebook, Amazon, Netflix and Google/Alphabet. Outside of the technology sector and growth style, returns have been muted.
We have largely avoided the priciest and junkiest sectors of the stock market, as well as the storied names, opting instead for equity investments that are understandable, undervalued and/or more suitable for where we believe we are in the economic cycle. Outperformance of high-P/E and/or low-earnings stocks and narrow market breadth are indicative of late cycle market behavior.
It is painful to watch from the sidelines as high-flyers go vertical. (Bitcoin and, more recently, cannabis stocks are extreme examples of this.) But we’ve seen this before: “dot-com” stocks in the late ‘80s, and the “Nifty Fifty” of the early ‘70s.
The following is a summary of portfolio changes that we have made over the course of the year:
1) Increased equity exposure – We believe the bull market has momentum to push higher. We have added to our equity allocation in growth- and balanced-oriented accounts.
2) Reduced alternative investment exposure – A confluence of technical and market factors have created challenging trading environments for some of these holdings, notable trend- following managed futures and factor-driven long-short.
3) Shortened bond duration – With the increase in short-term yields relative to intermediate- to-long-term yields, we have replaced much of our exposure to bond mutual fund positions with shorter-duration bond investments that yield almost as much. We have also added adjustable-rate securities. In so doing we have reduced our exposure to interest rate risk.
A final word on bonds: Bonds are unique from any other investment in that they provide certainty. Provided the issuer doesn’t default – which is why we conduct credit analysis – you know with mathematical precision what your return will be if you hold the bond to maturity.
We are here to serve you. Please call us at (318)675-0826 if you have any questions about your account(s).
Jack E. Ditt, Jr. William L. McCollum