|12 Mo. Change||YTD Change|
|10-yr Treas. yield||2.30%||2.40%||-0.10%||1.49%||+0.81%||-0.15%|
|Fed funds rate||1.0% to 1.25%||0.75% to 1.0%||+0.25%||0.25% to 0.5%||+0.75%||+0.50%|
(stock indices are before dividends; yield and rate changes are absolute changes)
Investors were generally happy this quarter with low volatility and markets trending upward. The US dollar has weakened over the last 11 months and contributed to the ongoing recovery of international stocks. Large tech companies led the way before softening towards the end of June while the benchmark Treasury popped in the last week from its low point of the year at 2.14%. Apple reached a market value of $800b, which is greater than the last 102 companies in the S&P 500 combined.
The Fed raised rates as expected in June, even though the benchmark Treasury was lower than before the prior two hikes, and indicated one more increase is likely in 2017. The Fed, which stopped adding to its bond portfolio in 2014, also indicated it would wind down reinvesting the interest from those bonds, beginning with $10b/ month ($6b from Treasuries and $4b from mortgage securities) and increasing each quarter to a monthly maximum of $50b. (Current reinvestment is $24b/month for mortgages and $17.5b/month for Treasuries, so the maximum could signal a slight principal reduction in bond holdings.)
Greece received the last installment of its $96.5b bailout by the EU, with capital controls (limits on cash) helping increase tax compliance and improving government revenues. President Trump’s announcement that the US is pulling out of the Paris climate accord was largely symbolic as it can’t take place for several years and a number of companies and states indicated they would continue with the accords anyway. China’s credit rating was reduced due to slowing growth and surging nongovernment debt, which has more than doubled since 2007.
Around 50% of homeowners who refinanced mortgages in the first quarter took out cash, compared to a high of 90% during the boom and low of 12% in 2012. Credit scores were the highest since 2005 (when the data tracking began) with an average of 700 and scores below 600 were at 20%, an all-time low from a high of 25.5% in 2010. Consumer confidence was steadily strong with “present conditions” the best since 2001 but with “expectations” tapering off in June.
Housing prices continued to increase at a faster pace than wages, although real income for May increased 0.6%, the best in two years. Prices nationally rose above the 2006 peak and total mortgage debt hit $14.4 tr, barely below the 2008 peak. Short supply of both new (housing starts were down in May, with a shift from multi-family to single-family homes) and existing homes (listings were down over 8% from a year ago) for sale is contributing to price increases. New household formations for home buyers has shifted to twice that for renters and first-time home buyers are 42% of mortgages, up from the low of 31% in 2011.
GDP growth for the first quarter was disappointing at a final increase of 1.4%. The good news is that growth was only up 0.7% at the initial estimate in April so the final revision was slightly encouraging. The change was largely due to an increase in consumer spending from 0.6% to 1.1%. Also encouraging was an increase in inventories and a drop in the May trade deficit to $65.9b from April’s $67.1b, with exports growing and imports declining.
Productivity, which is critical to faster growth, was revised from a decline in the first quarter to being flat and was up 1.2% from a year earlier. The average productivity for the last 10 years was 1.2% compared to 2.6% in the early 2000’s and 2.2% since World War II. The June jobs report showed more jobs added than expected and the labor participation rate increasing (more people re-entering the job market) so the unemployment rate ticked up to 4.4%. Average hourly earnings grew 2.5% from last year but employers are still struggling to find qualified workers.
Generally speaking, the best Looking Forward items are economic data or developments happening in the next six months or so. They are nice and quantifiable and while the underlying factors will continue to change with the economy they at least offer a finite measurement point.
Last quarter we veered more into the political arena for Looking Forward – Brexit and the pace and scope of legislation in Washington. As politics goes, these are about as quantifiable as it gets, with Brexit on a two-year time clock and legislation either passed or not (so far, not so much).
But the air is still being sucked up by political issues. The most obvious is the ongoing debate on health care – repeal, replace, adjust, do nothing. After one failed attempt in the House and two in the Senate, the future is even more confusing. With less than six months to go, tens of millions of people don’t know whether they will have coverage in 2018, what it might cost even if they are covered or what their other options might be. And insurers, whether they are seen as villains or simply as companies offering a product, are shooting in the dark as to whether they will continue to participate in the exchange.
Of potentially greater consequence is the looming crisis in state budgets. As of June 30, 11 states did not have budgets for the fiscal year beginning July 1. While budget compromises have now been enacted, Maine and New Jersey temporarily shut down most government activities and services and Illinois completed their second full year without a budget, falling precipitously close to junk bond status for state debt. These compromises kept state governments running but did not resolve the underlying problems.
Growing pension obligations may be a recurring theme but the even more fundamental challenge is simply reconciling spending with revenues. Legislators are either stupefyingly bad at basic math or simply don’t care about making ends meet. Political philosophies aside, these state governments are eventually going to be forced to match revenues with spending because they are legally prevented from sustaining long-term deficits and cannot go bankrupt; the public will be forever on the hook for the debts. This may be the precursor for governmental entities across the board to set aside differences, make tough choices and get their financial acts in order.
In his 2017 Mid-Year Review https://gordianadvisors.com/2017-mid-year-review/ Denis looked at the performance of various asset classes, sectors and investment styles. As is usually the case, there are a couple of surprises (Poland was the best performing country, bonds have held up despite the Fed increase, see comments on the yield curve below). Even more typical is the reversal of some factors from prior periods. Large growth stocks fueled by Apple, Amazon, etc., were the leaders in US stocks, which is the mirror image of 2016. Likewise, sectors meandered during the six months, making any sector selection very difficult. For example, financials and technology tracked each other pretty well for the first month and a half, then financials tailed off and technology shot up, but in June a nearly 20% performance advantage for technology narrowed to around 5%.
And once again, the remote chance of making accurate investment decisions ahead of time to take advantage of these shifts illustrates that indexing broad market segments and consistent, long-term investment philosophies are the best ways to meet long-term financial goals.
At the same time, we hear almost daily, through phone calls and email, from investment manager representatives who want to meet and discuss their fund or investment strategy. The pitch is always the same – our fund/strategy has performed well (based on selective data) and it will “add value” to client portfolios. We never take the meetings, which sometimes leads to the Sales 101 response of “don’t you want to help your clients?”
We pass on these pitches because we would rather spend our valuable time actually serving clients. And frankly, we simply can’t imagine hearing an investment presentation and concluding that it’s the best new thing and why did we not think/hear of this before. It’s not that we think we know everything; it’s just that we’ve been around long enough to know that all these narrowly focused approaches and investment vehicles eventually turn sour. Portfolios and clients suffer and the managers benefit along the way. In the meantime, we monitor the investment landscape and keep a close eye on the funds we have used in portfolios to make sure they are still doing their job.
If some new magic dust does happen to fall, we’ll be sure to scoop it up.
The Earth Is Not Flat But the Yield Curve Is Getting Close
For all the economic terms that can be associated with it, the yield curve is really quite simple. It is a line chart of interest rates for various maturities of Treasury securities, from one month all the way to 30 years. The steepness of this line can have implications for future interest rates and can be influenced by investor sentiment. As noted in the Markets chart above, year-to-date interest rates (the Fed funds rate) have gone up while the benchmark 10 year bond has gone down despite two rate increases by the Fed. These changes have made the yield curve more “flat” than normal.
The “normal” yield curve slopes upward from short-term to long-term for several reasons. If the market is anticipating a rise in interest rates, investors who are willing to lock in their money now demand higher rates to compensate for higher rates available later. There is also greater risk with longer term bonds because there is more uncertainty and more time for adverse events to happen that can impact the bonds. Investors always need to be paid more for greater risks.
After the election, many analysts thought the yield curve would steepen in 2017 with a stronger economy, the possible return of a little more inflation and Trump’s promises of tax cuts, infrastructure spending and regulatory relief. So far economic growth has not taken off (despite the administration’s continued projections of 3% growth somehow materializing) and many of those promises are looking less likely.
A flatter yield curve can send mixed signals. It can indicate market concern about overpricing in riskier asset classes, particularly stocks and real estate. It can also reflect some underlying reservations about growth going forward.
In any case, the yield curve will eventually return to a more normal steepness. What is uncertain is what “eventual” might mean and which end of the curve will move to steepen the curve– short interest rates going lower, which would be a reversal of the Fed’s recent increases and signals about more increases, or long rates going higher, which would require the market buying into growth and inflation.