With the arrival of more positive economic sentiment, more positive fundamental economic data — including employment and wages — and modest signs of inflation, we face a very different market picture than we did last year at this time. A year ago, with the U.S. still bearing the brunt of the decline in the price of oil and the dollar’s rapid appreciation, fear and pessimism were in the air.
The markets were also still hanging on every word from the Federal Reserve. Back in June, Fed Chair Yellen even dipped her toe in the water of “secular stagnation” talk — the fear that the global economy was mired in some longer-term, intractable problems:
“In the current environment of sluggish global growth, low inflation, and already very accommodative monetary policy in many advanced economies, investor perceptions of, and appetite for, risk can change abruptly… We expect the rate to remain, for some time, below levels that are anticipated to prevail in the longer run [because of] headwinds weighing on the economy… These headwinds… could persist for some time.”
What a difference a year has made. With bond markets still not taking the Fed’s projected path of rate rises seriously, Mrs Yellen took pains earlier this month to jolt them out of their complacency with public comments. In short order, market doubt about the March rate rise turned into near certainty, and on Wednesday, the Fed delivered as expected — raising the Fed funds by a quarter of a percent, and laying out a path for two more increases in 2017, and about three in 2018.
Watching the Yield Curve
One of the fundamental financial indicators that investors watch, including us, is the changing shape of the yield curve — that is, the relative behavior of short- and long-term interest rates. No indicator has a perfect track record, but an inversion of the yield curve — with short-term rates above longer-term rates — has preceded every recession of the last 50 years. On average, the inversion occurs 15 months before the subsequent recession, though there’s a lot of variability.
Even After Wednesday’s Announcement, An Inverted Yield Curve Is Not Imminent
Source: Bloomberg
In spite of the December and March rate rises, the anticipation of stronger growth has caused the longer end of the curve to rise faster, with result that the curve is steeper — further from inversion — than it was last year.
Together with several other key indicators — including trends in corporate profit growth — the yield curve suggests to us that a recession (and the associated bear market) is likely still a year and a half to two years away. While a correction is possible at any time, we anticipate that such corrections will be relatively brief and shallow, and will present buying opportunities for stocks with positive fundamental outlooks.
What Could Change This View?
If the Fed changed course, and adopted a much more aggressive pace of rate rises than they currently anticipate, this outlook could change. Mrs Yellen kept the door open a crack for such a development when she spoke in early March, saying, “Waiting too long to scale back some of our support could potentially require us to raise rates rapidly sometime down the road.” (Most likely, this statement was just hedging what she currently considers to be an unlikely eventuality.)
For now, given the Fed’s cautious, data-driven course, it seems unlikely. The “dot plot” shows the consensus of voting members of the FOMC about the future path of rate increases, and the bond market watches it closely. Below, you can see Wednesday’s dot plot, with a red line indicating the median anticipated rates.
What could force the Fed’s hand and cause them to adopt a much more rapid pace of rate increases? Primarily, a spike in inflation — which we do not anticipate occurring. We believe inflation will be present, and will increase, but quite modestly, partly because of continued U.S. dollar strength.
We do believe that the Fed is behind the curve; they probably should have embarked on this path of rate increases some time ago. We just don’t believe that their actions will imminently derail the performance of U.S. stocks (with some important exceptions, which we’ll note below).
Dots show rate anticipations of individual FOMC members
Red line indicates median of all voters
Source: Federal Reserve Open Market Committee, March, 2017 and Guild Investment Management
What Does All This Mean For You?
Let’s boil this down. What are the implications for your portfolio?
First, recession risk is currently low, and the next recession bear market is likely some time away. The yield curve currently suggests that a recession is not likely before 2019 or 2020. (We’ll watch carefully to see if the Fed changes its tune about the likely future pace of rate increases, because that could flatten the yield curve more quickly.) Our investment strategy has always involved working to avoid bear markets, and of course, we will keep you informed as we continue to monitor that risk.
Second, with recession risk low, GDP growth picking up, and corporate profits growing again after stagnating from 2014 to 2016, we’re positive on U.S. stocks (with some exceptions that we’ll note below). Given the current policy, sentiment, and economic environment, we continue to like high-quality large-capitalization companies that can grow, and that pay a modest dividend that they can maintain and raise. We continue to like companies in the financial and technology sectors.
Third, a strong dollar, even if it does not continue to strengthen sharply, will keep a damper on inflation, and will not be supportive for gold. We do not see great upside for gold in a scenario where inflation is present, but subdued, and where there is no global geopolitical turmoil unfolding. (These are the two main drivers of performance for gold.)
And fourth, even if the pace of rate increases remains controlled, rate increases are finally occurring after an unprecedented period of low rates, and we are witnessing the end of a very long bull market in bonds. Therefore, bonds and high-yielding bond-equivalent stocks such as REITs, MLPs, and others, face troubling long-term futures, and we do not believe they provide the reward-risk ratio that sober investors require.
In a nutshell: own high-quality, large-cap U.S. stocks that can grow; avoid bonds and bond-equivalent stocks, and until a recession comes into view, look at short-term market declines as buying opportunities.
Investment implications: What a difference a year makes. Last year’s talk of secular stagnation is over; GDP and corporate profit growth are back on an uptrend; and the Fed is talking forcefully so that bond markets will listen to its anticipated schedule of rate increases. Our takeaway is simple. The data suggest that recession risk is not imminent, and with corporate profits rising, that bodes well for many U.S. stocks. Corrections can happen at any time, and in our view, any near-term corrections will be buying opportunities. Inflation will be present, but likely subdued by dollar strength, and in the absence of strong inflation and geopolitical turmoil, gold will be challenged. Prospects for bonds and high-yielding bond equivalent stocks look dim against the backdrop of a thirty-year period of falling interest rates whose end is now in view. We like big-cap, high quality U.S. stocks on any correction, particularly financials and technology.
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