Chill in the Air

PaulNolte-2It’s back to the future, in more ways than one. Of course, for baseball fans, it is the prospect that the Cubs are closer to actually making the “prediction” in the Back to the Future II movie a reality. Yes, in 1989, the movie predicted the Cubs would sweep Miami. In economic terms Goldilocks is back! Could we be in that fairyland place where nearly everything is “just right”? Economic growth is modest, but not strong enough to elicit central bank forcing rates higher. Growth does not seem to be slow enough to worry about a recession and force central banks to embark upon yet another round of quantitative easing. While the economic data does not yet point to a recession, the underlying trend is decidedly poor. Retail sales, outside of auto sales, were poor. Industrial production also came in weak. Inflation, the one missing element for the Fed to get serious about raising rates, also remained low. International reports show a similar picture, overall economic conditions are not recessionary, but they are showing some weakness. The Fed will be grabbing some popcorn and sitting back to watch the movie instead of raising rates this year.

The stock market returned to what has been working for much of the year, healthcare, utilities and consumer staples, eschewing the recently popular industrial and energy sectors. The good news is that the underlying market is now acting better than it has all year. The rally seems to be much broader than earlier this year and provides some hope that the SP500 can clear the 2050 area that was the “breakdown” point two months ago. Investor sentiment has only just begun to swing toward positive territory and could provide some added juice in the weeks ahead. Investors have found that the past three months or so are tracking very closely to the markets in 2011. Back then the US debt was downgraded from AAA status and stocks fell nearly 20% from their April highs to September lows. While this year’s decline was not as severe, the same worries about higher borrowing costs have wreaked havoc this year as well. In 2011, stocks turned on a dime at the start of the fourth quarter and rose nearly 25% over the ensuing six months. Stocks are up 5% so far this month and seem to be following the 2011 blueprint. The less than perfect comparison is that from a valuation perspective, stocks were much cheaper in 2011 and earnings were still growing. Today, earnings are down 10% from the start of the year and may go lower based upon the early earnings reports so far this quarter. Will the past be prologue or just a tease? Earnings for the rest of the quarter may tell the tale.

Betting on a Fed increase this year has dwindled to the lowest level of the year. Interest rates have followed the betting as well, as long-term rates are down 0.25% since the Fourth of July. While treasury rates have declined, that is not necessarily true for all interest rates. Considered “risk free”, treasuries are the bonds of choice when worries surface. At the other end of the spectrum are high yield (formerly known as junk) bonds. It is instructive to look at the difference in yields between the “safe” and “risky” bonds to get a sense of investor’s views of the economy. Over the last 18 months the difference between the two has grown by a full percentage point. Similar increases in this “spread” have preceded economic problems or stresses. The high yield market is dominated by energy companies that may struggle to survive in a low priced oil market, but the changing dynamic of this market bears watching.

After the initial blast-off in early October, stocks returned to their “steady state” this week, as healthcare, consumer staples and utilities led the markets higher. Left in the dust was anything (again!) outside of the SP500. Our expectation coming into this year would be the focus would shift away from the SP500 as global stocks were (and still are) much cheaper than their US counterparts. Following a strong run in the dollar last year, the dollar continued to gain on foreign currencies as the US looks to be the strongest economy in an otherwise weak global market. Will the relative strength in the US pull up the remainder of the world, or will the world pull down the US? Investors cannot yet answer that question and is the main reason behind the volatility in stocks.

Investors are heading back to what has served them well early this year, large US stocks focused on healthcare, staples and utilities. Earnings over the next two weeks should fill in some of the blank spots in assessing both the US economy and global growth. The Fed is likely to be on the sidelines well into next year, so bond buyers can be somewhat comfortable buying 5-7 year bonds that capture a large part of the long-term yields without the price risks.

The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.