The Markets This Week

by Connor Darrell, Head of Investments

It was a busy week for financial markets, with a mixed bag of positive economic news and disruptive political developments.  On the positive side, the US unemployment rate continued to track lower, reaching 3.8% in May.  Unfortunately, that news was offset by two major developments in the global political landscape.

First, markets opened sharply lower on Tuesday as Italian political negotiations sparked fears that Eurosceptics (those who are opposed to European Union membership) were set to take control of the government.  The political situation in Italy remains complex and the long-term outlook uncertain, but those fears were somewhat alleviated later in the week as a more favorable consensus was reached on the re-establishment of the government following March’s inconclusive election results.

Then on Thursday, the topic of tariffs once again dominated financial news headlines when the Trump Administration announced that it would allow the temporary tariff exemptions (Initially granted when the 25% steel and 10% aluminum tariffs first took effect in March) for Canada, Mexico, and the EU to expire.  According to Goldman Sachs Investment Research, those countries accounted for approximately 40% and 48% of 2017 US imports of steel and aluminum respectively.  Canada and Mexico immediately responded with retaliatory measures and stocks slid lower on the news.

Amid the conflicting signals, US equities outperformed, and bonds generated small gains as investors sought refuge from some of the volatility.

The Markets This Week

by Connor Darrell, Head of Investments
Bonds rallied last week, with the 10-Year Treasury yield dropping back below 3% and the Bloomberg Barclays U.S. Aggregate Bond Index posting gains of 0.74%. Stocks produced mixed results, with the U.S. outperforming its International counterparts.

Another By-Product of “Low for Long” Interest Rates: Corporate Debt
Moody’s, a well-respected provider of credit research, issued a sobering report earlier this month warning of the potential for “a particularly large wave” of defaults on below investment grade corporate bonds when the next economic downturn eventually arrives. The report cites the low interest rate environment as a key contributor to a significant increase in the amount of corporate debt outstanding and a subsequent rise in the number of global non-financial companies carrying below investment grade credit ratings.

Coming out of the financial crisis, with interest rates at their lowest levels in decades, many corporations took advantage of the low rates to go out and borrow additional funds to invest in their businesses. And with investors starved for yield, even many companies that were in poor financial health were able to issue debt at relatively low rates. This has been beneficial to the overall investment climate and a tailwind for the stock market, but may leave many companies exposed in the event of a prolonged economic downturn.

Default rates on corporate bonds remain very low, but the Moody’s report highlights the need to be vigilant, even in strong economic environments. We have discussed in past communications that we find ourselves in uncharted waters with respect to monetary policy, making it even more important to be on the lookout for potential risks in the marketplace. Rising levels of corporate debt is certainly one of those risks to watch.

The Markets This Week

by Connor Darrell, Head of Investments
Both large cap stocks and bonds ended the week marginally lower, but the heightened volatility observed over the past few months seems to have waned for the time being. Internationally, stocks traded largely in line with those in the U.S., although emerging markets stocks had their worst week in quite some time. Emerging markets stocks have faced headwinds from the increasing strength of the U.S. Dollar, which reached a five-month high last week.

US small cap stocks were a bright spot last week, and have been all year. The Russell 2000, which tracks a broad basket of small cap stocks, is up over 6% so far this year, outperforming the S&P 500 by about 4%.

Oil Prices on the Move
It is easy to forget that there was a solid four-year stretch from December 2010 to November 2014 where the average retail price of a gallon of gasoline in the US was well over $3. But a confluence of factors (including technological advances that increased US oil production, as well as a concerted effort by members of OPEC to put a squeeze on those same U.S. producers) led to a massive decline in the price of oil beginning in late 2014. From peak to trough, the total price decline was over 70%, and consumers reaped the benefits for a number of years. However, that has changed rather dramatically in the last 12 months, as prices have come roaring back.

The surge in oil prices over the past year has been driven by a variety of influences, including increasing demand driven by strong global economic growth, cooperation between Russia and OPEC, economic collapse in Venezuela, and logistical inefficiencies disrupting the distribution of US shale oil. On top of this, the Trump administration’s decision to withdraw from the Iran nuclear deal and re-impose sanctions could lead to a decline in Iranian production, which would further deepen the supply shortfall.

In the near term, the rise in oil prices has the potential to increase inflation and pose as a headwind to economic growth (albeit not nearly large enough to offset the benefits of recent tax reform). We have discussed in the past that the Fed is watching inflation closely, as it is one the key indicators that helps to dictate monetary policy. However, the Fed is unlikely to be coerced into altering its path of normalization by something as fickle (and potentially temporary) as rising oil prices. It is more likely that the worst side-effect of the recent run up in oil prices will be some pain at the pump during the summer travel season.

The Markets This Week

by Connor Darrell, Head of Investments
Stocks posted their strongest weekly gain in over 2 months last week, with energy stocks leading the way amid further increases in the price of oil.  It certainly won’t be celebrated by those of us traveling for summer vacations over the next couple of months, but oil prices are likely to remain elevated if the Trump Administration is able to reinstate economic sanctions on Iran.  International markets also posted gains on the week.

Bonds had a relatively uneventful week, but remain under the microscope of many investors and media outlets as interest rates creep higher.  We discuss some of our thoughts on what the market might be overlooking in our update below.

The Bigger Unknown in Monetary Policy “Normalization”
Likely due to their direct influence over the interest earned on savings and paid on loans, the Fed’s interest rate decisions seem to get all of the attention when it comes to discussions of monetary policy.  However, faced with the unenviable task back in 2008 of combating the deepest recession in a generation, the Fed pulled out all the stops, using every tool in its arsenal to inject life back into the US economy.  As a result, in addition to the traditional (and oft discussed) avenue of pulling interest rates down near zero, the Fed also implemented multiple rounds of Quantitative Easing, an unprecedented expansion of Reserve Bank Credit (the Fed Balance Sheet).  This was accomplished by purchasing trillions of dollars’ worth of bonds in the open market in order to inject more money into the financial system and increase liquidity in markets.  The ultimate purpose of the policy is largely the same as the reduction in interest rates, but it is widely considered to be a much more extreme approach.

Between October of 2008 and December of 2014, the value of the Federal Reserve’s balance sheet swelled from $0.9 trillion to $4.5 trillion (see below chart from Argus Research) as it continued to purchase bonds.  Since then, the balance sheet has remained largely untouched, but the Fed has made clear in its communications that this will soon change.  The consensus among forecasters is that the Fed will begin the process of shrinking its balance sheet later this year by allowing maturing bonds to roll off and ceasing its reinvestment of coupon payments, to the tune of about $50 billion per month.

Like all markets, the bond market is driven primarily by supply and demand, and with the Fed reversing its policies, the underlying balance of supply and demand will undoubtedly be altered.  What would this mean exactly?  The ultimate results are very difficult to predict.  If the Fed is able to effectively telegraph its moves (as it intends), then markets may be able to adjust gradually with no major impacts.  But if the balance shifts more than anticipated, then a major dislocation could take place.  Under such a scenario, the laws of supply and demand would dictate that the oversupply of bonds on the market would drive prices down, and yields up.

Source: Argus Research

That short term rates will increase from here is highly likely and largely assumed by most investors, so in our view, the potential impact of the Fed’s balance sheet unwind, which would occur in addition to the trends already in place, is the bigger “unknown” as we move away from the accommodative monetary policies of the last decade.  Given its current size, it may be appropriate to say that we consider the Fed’s balance sheet to be the “elephant” in the room.

The Markets This Week

by Connor Darrell, Head of Investments
Both stock and bond markets trended downward last week, until Friday’s jobs report sparked a stock market rally. The Department of Labor reported that employers added 164,000 new jobs in April, and that the unemployment rate currently stands at 3.9%. This was the first unemployment reading below 4% since 2000.

Additionally, there are more than six million unfilled job openings throughout the economy; close to an all-time record. However, despite the continued imbalance in the supply and demand for labor, wage growth has remained slightly below expectations. Wage growth is one of the last pieces of the puzzle, and because of its potential connection to inflation, will be watched closely by the Fed as it steadies its march toward normalization.

A Wacky Earnings Season
Active traders often try to take advantage of earnings calls as an opportunity to buy or sell a stock ahead of its earnings report.  It’s a risky proposition, and one that we do not recommend in the current environment. Per Factset, 81% of S&P 500 companies have reported Q1 earnings in excess of consensus estimates, and overall earnings growth has been over 24%; the highest rate in seven and a half years. Even so, we have witnessed dozens of companies report earnings beats, only to sell off meaningfully during the following trading session. It seems the market has lofty expectations for further growth, and companies that do not raise their forward guidance to meet those expectations are being punished. As we continue to progress deeper into the economic cycle, the heavy emphasis on forward guidance rather than past results is likely to persist.

According to research from Wells Fargo, earnings growth for Q1 would be closer to 7% in the absence of tax reform, and once we reach 2019, year-over-year comparisons will not benefit from the tax reform boost. Add this reality to the confluence of risks that the market has begun to acknowledge rather than ignore, and it becomes a little bit easier to understand why markets aren’t quite ready to break out the champagne to celebrate a successful earnings season.

As the market continues to trend sideways with higher levels of volatility, asset allocation and diversification become even more important. Periods like these are the reason we diversify in the first place.

The Markets This Week

by Connor Darrell, Head of Investments
Last week brought with it a slew of positive new developments, both economically and geo-politically. Q1 GDP growth exceeded estimates, corporate earnings continued their positive momentum, and small steps were taken toward officially declaring an end to the Korean War (at long last). Despite all of the good news however, both equities (as measured by the S&P 500) and bonds (as measured by the Bloomberg Barclays US Agg) finished flat for the week. Bond markets have faced headwinds all year from increasing interest rates, but we continue to emphasize that rising interest rates do not necessarily mean doom and gloom for bond investors. While shifting interest rates will cause some volatility in bond prices, investors who plan to continue holding bonds until maturity will not be harmed by the interim price movements, and those who hold shorter term bonds in their portfolios will be well positioned to reinvest as rates creep higher. Additionally, rising interest rates will be welcomed by savers and those who are looking to cash as a respite from volatile equity markets.  There are winners and losers under every scenario.

We are presently in the midst of one of the strongest earnings seasons in recent memory, but the stock market has barely budged. The lack of movement suggests that most of what we are seeing was already reflected in stock prices, and that the market is beginning to acknowledge that 2017’s huge gains left us with a much shorter climb for 2018 and beyond. Put simply, the forward outlook is quite a bit different than it was just 6-12 months ago.

A Return to “Normal”
2018 is likely to become the year of mean reversion. The Federal Reserve has made it abundantly clear that it intends to begin increasing interest rates at a steadier pace. The term that bankers use is “normalize,” and it really is a fitting term for what is going on in the economy and in the markets. Volatility in the stock market, CDs paying more than 0.5%, and a central bank balance sheet that doesn’t contain trillions of dollars of bonds are all “normal.”

After a decade of abnormal, a return to normal is going to take some getting used to.

The Markets This Week

by Connor Darrell, Head of Investments
Earnings season is now in full gear and the initial data has been quite strong. According to Factset, a little less than 20% of S&P 500 companies have reported earnings thus far, and the blended earnings growth rate for these companies has been 18.3%. The healthy earnings growth pushed equity markets higher for the second straight week, while bonds finished down as the ten year Treasury note pushed close to 3%.  The 3% threshold will be an important milestone in the normalization of interest rates.  Rising interest rates have been discussed ad nauseam in financial news outlets, but are a natural part of the economic cycle and should be expected to continue as the economy strengthens. The Bureau of Economic Analysis will release its first estimate of Q1 2018 GDP growth this week, and investors will likely be focusing on the year over year numbers as they look for further evidence of an improving economy.

What Happened To the Infrastructure Bill?
Following the passage of tax reform at the end of last year, it was widely expected that lawmakers would quickly shift their attention to infrastructure. For the time being, scandals, international tensions, and unrest within the Trump Administration seem to have slowed the legislative momentum established following the tax victory, and it now looks unlikely that an infrastructure spending bill will be introduced in Congress until after the mid-term elections in November. From a market perspective, the delay is unlikely to have major implications, but from an economic growth standpoint, an infrastructure bill could be an interesting wild card.

In terms of economic impact, infrastructure spending has similar effects to tax cuts. The increased spending on projects should have a positive impact on labor markets and create new jobs. In theory, those workers then have more money in their pockets to spend on goods and services, which should be a tailwind for economic growth. Many observers have been quick to point out that some aspects of the tax bill are “front loaded”, in that their effects phase out over time. An infrastructure bill passed during 2019 could potentially pick up some of the slack and help to carry growth momentum a little bit further, essentially allowing us to squeeze even more juice out of this long expansion. Given that outlook, it is entirely possible that this becomes the longest economic expansion in history, exceeding the period from 1991 to 2001 when the US experienced 120 straight months of economic growth. Given that the current expansion is already over 105 months old, there isn’t a lot further to go.

Of course all of this is incredibly difficult to project with any real degree of confidence, especially when considering the myriad of external factors and the possibility of significant changes to the composition of congress following the mid-term elections. But even without further stimulus in the form of infrastructure spending, the economy remains on firm footing and the risks of recession remain relatively low in the immediate future.

The Markets This Week

by Connor Darrell, Head of Investments
Despite a busy week in Washington headlined by Speaker of the House Paul Ryan stepping down from his post, stocks managed to climb 2% higher last week. The market’s gains were bolstered by a rebound in technology and energy stocks.  Facebook CEO Mark Zuckerberg endured two difficult days of Congressional testimony surrounding data security and privacy on the web. The testimony was well-received by the markets. Bonds were down slightly after the minutes from the most recent Federal Reserve meeting were released and suggested further rate hikes remain likely.

Now that the first quarter of 2018 is in the books, investors can shift their attention to the first earnings season under the new tax laws. Throughout Q1, the stock market was hampered by shifting inflation expectations, a selloff in technology stocks, and fears of an all-out trade war, but the steady flow of new corporate earnings data that is set to commence this week should provide investors with a (much needed) new area of focus. According to Factset, the market is expecting 17.1% growth in corporate earnings, which would be the highest growth rate since 2011. The strong estimates are a product of the reduced corporate tax rates under the new law, as well as increasing consumer confidence and economic growth.

Time to Follow Through

The optimism for earnings growth is in stark contrast to some of the nervousness that markets have exhibited over the past few months, where intra-day selloffs of more than 1% have been commonplace.  That divergence is in many ways a microcosm of the increasingly conflicting signals that investors must grapple with moving forward. Shifting economic policies in the US and the potential for rising inflation and interest rates are offset by improving economic growth and consumer confidence around the world.  But if Q1 taught us anything, it’s that expectations can only get us so far. At some point we need to see real tangible progress, and Q1 earnings season is the market’s first opportunity to prove to us that all the optimism surrounding tax reform’s impact on corporate profits was justified. If earnings live up to all the hype, stocks could find more stable footing and finally put some of these trade fears in the rear view mirror. If it doesn’t, we could all be left a little disappointed.

The Markets This Week

by Connor Darrell, Head of Investments
CLICK HERE TO GET TO KNOW CONNOR

After a rough start to spring, the market seemed to turn a corner during the middle of last week, when on Wednesday equities opened sharply lower but came roaring back to close the day in the black.  However, more disruptive trade talk on Friday erased all of the week’s gains. The Department of Labor also released its March jobs report on Friday, but anyone looking for an encore to February’s blockbuster report to provide some respite was left disappointed. The economy continued to add new jobs, but the rate of growth (103,000 new jobs) came in below expectations.

For equity investors, the transition from 2017 to 2018 has not been easy to stomach. Volatility has become the new norm, and news headlines that would have been shrugged off a year ago are now sending shockwaves throughout investors’ portfolios. We expect this trend of increased volatility to continue as markets come to terms with a much wider range of factors to consider. Monetary and fiscal policies are now pushing in opposite directions (the Federal Reserve’s policy of raising interest rates is considered to be contractionary, while tax cuts are considered to be expansionary), and rising trade tensions have added a new dynamic to the equation. All of this is occurring as we are yet another year further along in the economic cycle.

Volatility: Where Economics and Psychology Meet

Periods of heightened volatility are uncomfortable, but provide an excellent opportunity to reflect upon the psychological aspects of investing. When markets are firing on all cylinders, it can be awfully easy to forget that investing involves risk.  Ech and every one of us has a different level of tolerance for how much risk we are willing to accept, but often times we don’t know our true tolerance until we experience real volatility. If you find yourself losing sleep over the ebbs and flows of the equity market, then that probably means your portfolio is too aggressive. In many ways, the best portfolio allocation is not the one that maximizes your return, but the one that best aligns with your financial goals and risk tolerance.

Morningstar, a well-respected voice in the investment community, released a study back in 2017 that explored why the average portfolio has struggled to keep pace with the overall market. Their conclusion was that many investors try to time the markets, a notoriously difficult (if not, impossible) thing to successfully implement on a consistent basis. Not only is this approach typically unsuccessful, but it also adds transaction costs and can be very inefficient from a tax standpoint. Over the long term, the best portfolio strategy is the one that enables you to remain disciplined and “in the game.” Sometimes that means building a portfolio that may not keep pace with every bull market, but will provide you with peace of mind when the going gets tough. The ability to match your portfolio with your goals and risk tolerance, in addition to their role as a behavioral “coach” during periods of market stress, are two of the most significant benefits of working with an advisor that is familiar with your unique situation.

The Markets This Week

by Connor Darrell, Head of Investments CLICK HERE TO GET TO KNOW CONNOR
It was another bumpy week on Wall Street, though markets closed out the month of March and rolled into the holiday weekend on a positive note.  Bonds outperformed stocks as the 10 year treasury yield slipped down to 2.77% after reaching as high as 2.94% during the middle of the prior week.  A lot has been made of tariffs and trade policy over the past few weeks, and we touched upon that a bit in last week’s update, but moving forward our primary focus is elsewhere.  See below for more details.

What We Are Focusing On
As investment managers, we must always be challenging ourselves to identify possibilities that markets haven’t yet appreciated.  After all, a portfolio manager who follows the common “consensus” will never outperform.  Sound risk management is about recognizing risks in the market before they have major impacts on asset returns, and identifying strategies that can mitigate their effects on a portfolio.  As such, we are constantly asking ourselves “What could conceivably transpire that would cause us to fundamentally change our market outlook?”

Following years of historically low levels of volatility, we believe that the equity sell-offs in February and March were simply a return to what might be considered “normal”, and that economic fundamentals remain supportive of further gains.  However, as we evaluate the state of the economy and markets, we see two interrelated risks that could temper our optimism; interest rates and inflation.

Since the 2008 financial crisis, central banks around the world have taken extreme measures to try and breathe life back into the global economy.  Pushing interest rates lower and lower in an attempt to encourage lending and stimulate the economy.  Over longer periods of time however, interest rates are driven primarily by inflation and growth expectations, not central bank policy.  The chart below shows the US Inflation rate alongside the yield on the 10 Year Treasury.  As you can see, there is a strong relationship between the two.

There is a theory in economics that inflation should be negatively correlated to the unemployment rate in an economy.  The logic is that as the unemployment rate declines, there are fewer workers available for hire, and companies must increase wages to attract new employees from a smaller supply of available workers.  These increased wages put pressure on profits and force companies to increase prices, leading to inflation.  While far from an infallible rule of economics, this phenomenon has been observed through a variety of different periods in history.

With the US unemployment rate approaching its lowest level since the turn of the century (which itself was the lowest level since May of 1969), the potential for rising wages and input costs to begin putting upward pressure on inflation has increased.  When we combine this possibility with the fact that interest rates have been moving steadily lower for over 35 years (see chart from above), we believe it will be incredibly important to watch inflation expectations moving forward.  Since long term trends tend to break suddenly rather than gradually, a meaningful upward shift in inflation expectations could impact interest rates and cause disruption in the market.

Building upon the notion that portfolios tracking consensus expectations do not outperform, the below chart shows how inflation expectations have evolved since we emerged from the financial crisis.

The 10 Year breakeven Inflation Rate is calculated by subtracting the yield on 10 Year Inflation Protected Treasuries from the yield on 10 Year Treasury Bonds and is used as a proxy for the market’s expectation of inflation over that time period.  Thus, we can gather from the chart that inflation expectations have remained quite subdued over the past ten years or so.  We saw a slight increase recently, but far from meaningful given expectations are still very close to where they were back in 2016.  The key takeaway from this chart is that markets are still not convinced that inflation, and therefore long term interest rates, will push significantly higher over the next few years.  We at Valley National are not “convinced” either, but we do believe that there exists a distinct possibility that inflation expectations are adjusted upward as economic growth continues to improve and unemployment continues to decline.  Shielding a portfolio from this risk involves reducing interest rate sensitivity by shifting towards short term bonds.  We view this as relatively inexpensive “insurance”, since it does not require investors to sacrifice a significant amount of income given that bond yields are already at historic lows.  If you have any questions about specific strategies for your portfolio, please contact your financial advisor.