October 2018 Newsletter: Curve Ball Season

0

Originally published on October 8th, 2018 by Tony DiGiovanni via LinkedIn.

The summer has come to a close and for the first time in forty years, all four major Detroit sport teams are terrible. The Tigers are finishing up a mostly forgettable season. The Lions just started an already forgettable season, and there isn’t much hope for the Red Wings nor the Pistons – though the latter may actually make the playoffs this year. Alas, not all is lost. The US stock market resumed its upward trend with returns surpassing 7%. International markets and bonds didn’t do nearly as well with returns less than 1%, but at least positive. This quarter also marked the 10-year anniversary of the financial crisis. We’ve come a long way.

Thus, Detroit sports notwithstanding, it was a pretty good quarter. In fact, two companies eclipsed the trillion dollar mark in value. For those interested in seeing what a trillion dollars looks like, enter the following address in your browser: http://www.pagetutor.com/trillion/index.html

Suffice it to say, it’s a lot of money. The natural question that usually follows such a good quarter is, “When will it all end?” Many people look at the current toxic political environment and scratch their heads at the success the market is enjoying. As investors, it is important to look through the headlines and separate the noise (lots and lots of noise) from the relevant facts (no fake news here).

On the positive side, earnings continue to surprise. For 2018, earnings are now projected to be 32% higher than last year. A good portion of the boost comes from one-time gains from the corporate tax cuts. Still, next year’s growth is expected to continue with earnings expectations 10% higher. The business environment couldn’t be better. Unemployment is low, yet wage inflation is still tame. Interest rates are rising, but still quite affordable. Valuations are creeping higher, but not relative to next year’s earning’s estimates.  In a nutshell, low interest rates with low inflation in a high earnings growth environment tend to favor stocks.

On the negative side, well, there’s that toxic political environment. Politicians have always been a noisy bunch, but this feels very different and perhaps even dangerous in the long run. Policy mistakes for political gain is probably the biggest risk from such an environment.

The tax cut bill is one example of a potential policy mistake for political gain. Time will tell, and there were parts of it that were quite good. While it certainly helped corporate profits and valuations, it will significantly add to our bloated debt levels. The tax cuts did not come with a corresponding cut to federal spending, and the extra growth from this stimulus will not be enough to offset the lower rates. If anything, spending has gone the other way. This will be a problem someday, though the timing of trouble will be extremely difficult to foresee. For now, the market is focusing on profits.

Adding to the debt problem is the current rising interest rate environment. The Fed raised rates again this quarter and will most likely raise them three to four more times in the next year. This poses a few problems. First, higher interest rates means higher debt service for the bloated debt load we just talked about. Second, consumers and companies that have to pay higher rates mean they have a harder time borrowing which tends to cool the economy. This is actually the intent. The Fed’s main concerns are employment and inflation. The unemployment rate dropped to 3.8%; this makes the Fed nervous inflation will creep up. The tricky part is getting the rates to neither spur nor hinder growth.

Of more concern is the shape of the yield curve. We have discussed this over the last two quarters. Sometimes it helps to see it in a picture (see graph). The green line is the current curve. Each point corresponds to a different interest rate at different maturity levels. Thus, the upper right circle shows the current 10-year yield (around 3.1%). The circle to the left, but still on the green line shows the current 2-year yield (around 2.8%). The difference is the spread (0.3%). As you can see from the arrows from the blue lines (the curve from last year), the 2-year yield has risen much faster than the 10-year causing the curve to flatten. The Fed controls the very short-term rates (currently just above 2%). If they raise rates three or four more times and longer rates don’t rise, we will have a nearly flat curve. This is dangerous as it usually only flattens or inverts (short term rates higher than long term rates) prior to recessions.

Chart – Yield Curve 9/30/17 to 9/30/18

Source: Bloomberg, White Pine Investment Co.

For now, the risks to the economy and profit growth are minimal. The problems we may face are longer term in nature. Recessions don’t usually start for months after the yield curve inverts. Using that as a guide, we probably have another year before it becomes a major concern. How Congress and the Fed navigate this road will be telling. Perhaps by then, one of our sports teams will be worth watching again.

Leave a Reply

Your email address will not be published. Required fields are marked *