We would never attempt to “call a top” in markets for we think that “a fool’s errand”. But we are mindful that prices do not rise forever. There are plenty of pundits who have worried aloud about the advanced age of this equity “bull market” in the US. We have not been one of them because we believe that bull markets do not die of old age. There has to be a catalyst and usually that “tipping point” is the onset of a recession. We see no evidence of a recession for the foreseeable future in America and for that matter most of the developed and developing world because the world is in an unusual period of synchronized growth. Nevertheless, it is wise to be watchful. Here are some “sign posts” which will help to guide us going forward.
Consumer confidence is high, as is small business optimism.
Unemployment is very low. While none of this is bad theoretically, taken to an extreme (and some might argue that we are there or close) when “animal spirits” are let loose, there could well be unintended consequences. What consequences could be significant? With employment high and confidence robust, investors fear less and demand more return, assuming more risk. They no longer want the safety of low-yielding liquid money, which was in high demand during the “Great Recession” when people were fearful.
As can be seen in the above chart, savings deposit growth has fallen dramatically since 2009. Further, during “the dark days” when investors were not interested in risk, neither were the banks. Instead of lending money to entrepreneurs starting new businesses, banks hoarded deposits and lent them conservatively to the US government (buying Treasury bonds), building excess reserves.
So “safe” money was in great demand as reflected by historically low yields. Investors were not interested in the returns they were getting on their cash – but were very interested in the RETURN OF THEIR CASH. That time has passed. Investors are looking for something other than safety. Deposits lose their appeal as an investment and capital is re-directed to riskier assets which potentially generate higher returns.
In addition to investor demands for higher yields on money, low unemployment could spark wage rate escalation which could in turn push inflation up in the US and the Eurozone.
Source: Bloomberg, 7/31/17
Right now, this is not a worry as seen above. But it is a potential concern.
If “junk bonds” blow up, it could be a signal that a recession is not far in the future. Higher yields on “High Yield” bonds would suggest that investors are nervous about the economy – about getting their money back – and want a greater yield to reward them for the perceived heightened risk.
Source: Bloomberg, 7/31/17
So we will watch the high yield bond market closely. If high yield paper starts to yield what it did in 2009, a stock market correction is probably in the offing.
If the yield curve flattens (i.e. yields on the 10-year Treasury and the Fed Funds rate are equal), then a recession might be close. It is anomalous for short and long bonds to yield the same. Typically, long fixed income yields more than short because an investor is taking more risk the longer the maturity of the paper. When long paper equals the yield on short bonds or worse yet, yields less than short term paper, it can mean that bond investors think a weak economy is near.
Source: Bloomberg, 7/31/17
If the dollar rallies vs. emerging market currencies, this would hurt earnings from US multinational companies. An earnings recession could cause a stock market correction.
Source: Bloomberg, 7/31/17
So these are the “sign posts” to help us along the way. These are not the only signals we will use – but they are important. We are certainly not complacent. We are watchful, but not fearful yet.
PREDICTIONS FOR 2017
1) S&P 500 corporate earnings +10% – 15%
Yes – So far earnings better than expected
2) Inflation to range from 2.5% – 3%
No – Recent numbers have been lower than expected, but still believe inflation will appear.
3)Business investment up due to cuts in corporate tax rates & overseas profits repatriation
Yes/No – Up 2-3% so far this year. Confidence is High. Still expecting cuts in corporate tax rates and profits repatriation
4)Government spending up due to infrastructure investment
Yes – To come later this year, perhaps.
5)Personal consumption up due to tax cuts & wage gains
Yes/No – Consumers are upbeat before tax cuts
6)Real GDP growth +3%
No – Expect improvement later in year
7)The Federal Reserve will raise the Fed Funds rate by 0.75%
Yes – Fed is “on course”
8)Bond prices will drop, yields rise (10 year Treasury yield 3.5% – 4.25%)
No – Bond demand remains strong
9)The Treasury will issue bonds with 40+ year maturities to take advantage of still historically low interest rates
Yes – Being actively researched by the Treasury
10)Equity prices will rise on the back of higher earnings & lower bond prices
Yes
A FINAL THOUGHT
A FINAL FINAL THOUGHT…
The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC. These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. The reported numbers enclosed are derived from sources believed to be reliable. However, we cannot guarantee their accuracy. Past performance does not guarantee future results.
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