| 12 Mo.
|10-yr Treas. yield||2.85%||2.74%||+0.11%||2.30%||+0.55%||+0.45%|
|Fed funds rate||1.75% – 2.0%||1.5% -1.75%||+0.25%||1.0% – 1.25%||+0.75%||+0.50%|
Other than large tech stocks, the quarter ended with a relative whimper. The US dollar surprisingly strengthened, hurting international investments. As the US announced tariffs on $50 billion more of Chinese imports, the EU and Canada also became more vocal about their displeasure with tariffs. It is a big news headline, but the effects so far are isolated, with uncertainty being the biggest problem unless and until retaliatory measures kick in. While the month of April showed the largest budget surplus ever on higher tax receipts, the fiscal year-to-date deficit is 5% higher than 2017. The Congressional Budget Office projects annual deficits to hit $1 trillion in 2020 and then keep growing.
As markets develop and shift, investment capital adjusts as well. Private equity funds, which invest in companies using significant amounts of debt and eliminate public ownership, are sitting on $1 trillion of cash searching for investment. Leveraged buyouts are up 44% this year and mergers and acquisitions are up 54%.
The Fed raised rates for the second time in 2018, as expected., with consensus being two more possible increases in 2018, three in 2019 and one final increase in 2020 to get rates just above the “neutral” level of 2.75% to 3%. Importantly, they dropped the language of holding rates below neutral “for some time” but also indicated that higher inflation may not result in faster rate hikes. The Fed’s preferred inflation measure increased 2.3% YOY, the most in six years, while even core inflation was up 2% YOY. Incomes creeped a bit higher while consumer spending grew at a slower rate, causing the savings rate to rise to 3.2%.
New home sales were strong and up nearly 9% from the prior year, and housing starts hit an 11-year high in the face of tight construction labor and higher lumber prices. Existing home sales were also up over 6% but available supply was down 6%. The combination of tight supply and higher mortgage rates led to the lowest housing affordability in 10 years, with housing costs rising faster than wages in 64% of locations. The median-priced home now requires 31.2% of income compared to the historic average of 29.6%.
The job market is still strong with unemployment dropping to 3.8%, the lowest in 18 years. Job openings are the highest since tracking began in 2000 and there are as many openings as unemployed workers; job skills is the challenge to matching workers to jobs. Wages grew 2.7% YOY and overall consumer confidence remained high, although the “expectations” component hit a low for the year. Household debt eclipsed its peak from 2008, hitting $15.7 trillion. Mortgages were actually down as a percentage of the total but consumer credit, and student loans in particular pushed the total higher. Final GDP growth for the first quarter was revised down a bit to 2.0%, with consumer spending at the slowest pace in five years, but forecasts for the second quarter are strong.
The European Central Bank is dealing with different circumstances as growth is slowing in the eurozone. The ECB began its bond-buying in 2015, six years after the Fed, and the deposit rate for excess bank deposits is at -0.4% and expected to stay there. Still, the ECB announced that it will start to wind down its bond-buying program by the end of 2018.
No surprise that there were plenty of developments on the political front. In May, President Trump made good on his promise to pull out of the Iran nuclear agreement. President Trump and Kim Jong Un of North Korea met in an historic summit with some promise of denuclearization but much is still to be done. If North Korea does take steps to disarm and engage the broader world it will be a boon to China; in the meantime, the US stopped its military exercises with South Korea. In a surprise announcement, Anthony Kennedy is retiring from the Supreme Court after serving as a “swing vote” for over 30 years. President Trump will now move to have a conservative replacement confirmed before the November mid-term elections.
In a close decision that crossed ideological lines, the Supreme Court overturned a 50-year old precedent that forbid states from collecting sales taxes unless the sellers maintained a “physical presence” in that state. As internet sales have boomed, this precedent has meant that nearly $34 billion annually in sales taxes goes uncollected. States will likely begin taxing all online sales, reducing an advantage that some online sellers boldly advertised.
This change can’t come soon enough for traditional retailers who need every little bit of help they can get. Online retail sales have been growing at three to four times the rate of retail overall, with brick-and mortar sales growing much slower than overall. The number of online shoppers, the frequency with which those shoppers transact and total online sales all continue to grow rapidly.
The last couple of years have been extremely difficult for retailers. In 2017, over 7,000 stores closed, with over 3,000 more closing so far this year. There were plenty of bankruptcies as well, with 26 major retailers (each having more than $50 million in liabilities, so they weren’t small local shops) declaring bankruptcy in 2017. These included well-known companies such as The Limited, Toys ‘R US and Radio Shack (for the second time in three years). Even the recession year of 2008 saw only 20 similar retailers close. So far in 2018 another seven major retailers have declared bankruptcy. Mall occupancy rates hit a new low since the recession.
Venerable Sears (see the history of the Dow below) has been symbolic of the challenges of retailers. Sears’ share price has fallen 73% in the last 12 months even as the overall retail sector index has rallied 18%. Sears continues to close stores, with 426 in 2017 between Sears and K-Mart and another 186 either closed or announced to close in 2018. That retrenchment leaves Sears with 40% fewer stores than at the start of 2017 and the closings have not boosted anyone’s expectations that they can reverse their slide. In the meantime, Sears has either sold valuable assets (Craftsman tools were sold to Stanley) or are evaluating sales (Kenmore appliances) to raise cash.
Workers have not fared any better than retailers. Even though retail still accounts for over 15 million jobs, 66,500 net retail jobs were lost in 2017 and over 1/3 of all job cuts in 2018 have been in retail. Retail job losses have especially hit young, elderly, female and minority workers who have traditionally not had the skills to make a career change. Ironically, the otherwise strong job market has meant retailers have had to improve pay, which has led to more automation and more job cuts. It is sometimes difficult for shoppers to find assistance in stores, further driving sales online.
Brick and mortar retailers are not going away and some areas like home improvement have held up well. But if the leveling of the sales tax playing field gives retailers a bit of room to maneuver it will still be up to the retailers to figure out how to stay afloat long-term.
The Fed has raised rates twice already this year and it looks likely there will be two more increases by year-end. Everyone knows that higher interest rates mean lower bond prices and with the Fed broadcasting their intentions far in advance it is little surprise that bonds and bond funds have had, relatively speaking, a miserable year. Our bond allocation has had a shorter duration, or sensitivity to interest rate changes, than the overall market for several years and it is well-diversified across bond sectors, with low exposure to more volatile junk bonds.
It’s fair to ask, though, why we don’t just liquidate the bond allocation and go to cash if there was ample warning of increased rates and cash is even starting to pay some reasonable yield. (Reasonable, of course, is still not at historic averages but it is a welcome change after years of little or no income for holding cash.) Once rates have stopped going up, the bond allocation could be reinstated at higher yields and without any loss in principal.
As usual, things that look simple in theory are not so simple in reality or in practice. Despite the Fed’s announced intentions, the changes in rates are not a smooth path and so the impact on the bond market is not smooth either; there can be periods of flat or even positive returns for bonds during the period of increasing rates. Different parts of the bond market will also react differently given other factors like economic growth and fiscal policy, so the diversified approach will capture those differences without getting stuck in a bond sector that suffers the most.
Trying to “time” the bond market through interest rate changes is a timing decision like any other, and as such it is exceptionally difficult to get both sides of the timing decision right. In the case of bonds, the potential lost income from being out of the bond market for too long could largely offset the advantage of avoiding some of the price decline.
Finally, one of the roles bonds play in a portfolio is to offset the risk of more volatile investments like stocks. Simply put, even a miserable year for bonds is nothing like the potential decline in stocks and it was only 10 years ago that the stock market began its 50% slide. Any price decline in the bond allocation could be seen as the price of “insurance” against such a large decline in stocks. And if the stock market were to hit a rough patch, some bond sectors would likely benefit as investors invariably flee to quality during stock upheavals.
Make no mistake, we aren’t happy that the bond allocation is struggling. But with broad diversification, shorter duration and a blend of index and actively managed funds, the bond allocation is continuing to do its job. It will benefit our clients in the long run.
A Long Chapter Comes to a Close
After cutting its dividend in half, declining in price over 40% in the last year and half and struggling to deal with its broad array of business segments, General Electric (GE) was removed from the Dow Jones Industrials in June and replaced with Walgreen’s. GE had long been viewed as the bluest of blue chips and was the last of the original companies that were included in the first Dow Jones Industrial Average in 1896. GE was in and out of the Dow twice in the early years but had been in the Dow continuously since 1907.
The Dow Jones Industrial Average has been continually revised to reflect the changing nature of the US economy, reaching 30 companies in 1928 and then staying at that size. A common criticism of the Dow is that it has too few companies to fully reflect the dynamics of the economy, especially compared to larger measures like the S&P 500, with 500 companies. But the Dow has survived as a steady reference point for the stock market, as evidenced by its frequent use by newspapers, analysts, politicians and broader media.
In fact, just browsing the history of the changes in the Dow is a walk through the 20th century. The rise of the automobile was represented by a one-year appearance by General Motors in 1915 (it came back to stay eight years later), followed by Studebaker and Mack Trucks. Likewise, the advent of air travel led to the inclusion of Wright Aeronautical in 1928. Retailers were added early on, with Sears and Woolworth both added in 1924; today retail is represented by Wal-Mart (added in 1997) and Home Depot (1999).
The rise of the consumer and changes in lifestyle and buying habits are clearly reflected in the Dow’s evolution (tobacco was included from the start). American Can was included in 1916 (early convenience food?), Paramount Pictures joined the average in 1925 (the rise of entertainment) and Victor Talking Machine (the Apple of its time?) in 1929. Today 11 of the 30 companies in the Dow are consumer-related, even excluding financial companies and retailers. Surprisingly, financial companies were not represented until 1982 with American Express; today there are six financial companies in the average.
The last change prior to GE was in 2015 when Apple replaced AT&T. GE was a market and economic barometer for over 120 years. What are the odds that Apple, the Dow Jones Industrial Average or even the stock market as we now know it will be around in 120 years?