Summer Heat Affecting Markets

PaulNolte-2As America celebrates Memorial Day, we pay tribute to those who have given their lives in our nation’s wars. It has, much less formally, also become the first day of summer. As kids rejoice at the thought of no school for a few months and parents wonder what to do with their kids for those months, the markets are wondering what the Fed will be doing during their summer. They will have two meetings, mid-June and the end of July, it is expected they will raise rates at one of those meetings. The most likely choice will be July since Britain votes on staying in the European Union just after the June meeting. After all the chatter from the various Fed governors over the past weeks, Fed Chair Yellen, in comments at Harvard, indicated a rate increase would be appropriate in the coming months. Of course the Fed has been known to back away from such certainty, but for now the Fed will be busy this summer increasing the cost of credit. The focus of
investors will also be shifting during the summer to the coming election, which elicits this quote from Mark Twain: “Patriotism is supporting your country all the time, and your government when it deserves it.”

The markets barely blinked at the comments from Yellen, indicating investors are prepared for the inevitable increase in rates. The strong rally from the February lows and near doubling of oil prices have given the Fed the green light to hike rates. Now within a day or two of good trading of all-time highs, the SP500 may also be set to take that leap higher after trading sideways for two months. Too be sure, there remain plenty of problems with stock prices at current levels from a
long-term perspective, but momentum seems to be on the side of the bulls for the short-term. The most common metric used for the health of the economy has been housing, which suffers from lack of “inventory” and an uptick in demand. The larger service economy seems to be bumping along, while manufacturing remains lethargic at best. The employment report due at weeks’ end will provide the fuel for a June or July rate increase. Overall job creation has slowed from last year and the revisions have been lower in 12 of the past 15 months. Average hourly earnings growth is up 2.5% compared to a year ago, but that still pales to other “boom” times when wages were up over 4% annually. There are some warts on this economy and the markets. But so far, investors have been projecting better days ahead and have invested

The bond market is calling BS on the Fed. Interest rates, after a surprising drop early in the year following the last rate increase by the Fed, have remained near the lows of the year. The Fed controls the short-term rates, which have ticked up a bit over the last few weeks, but it does not “control” longer-term rates, which is more a function of inflation expectations. The difference between short and long term rates, “the spread”, has narrowed to the lowest levels since the crisis. Historically, when short-term rates are above long-term rates, a recession is imminent; however we remain still a long way from that point. Surprising has been the bond model, which still projects lower rates ahead, based upon commodity prices, interest rates and the utility average. The Fed is trying hard to talk up rates, but investors still do not believe the economy is strong enough to warrant those increases just yet.

If we use various parts of the markets to help determine the strength of the economy, we might see a different picture than what is being portrayed by the Fed. Transportation would be the first stop, as rails and trucking move all the various goods to markets around the country. Rail stocks have trailed the market since the turn of 2015 and although they bounced early in the year, have been heading lower since mid-March. A broader index, adding in airlines and trucking, show a similar pattern. The market has been led by energy and material stocks so far this year, two of the smallest components within the market. The other two big winners have been the dividend rich utility and telecom sectors that, like bonds, have performed well in the face of the call for higher interest rates. The two laggards have been healthcare and financials. Financials are supposed to benefit from an increase in rates, but offsetting that benefit has been the narrowing of the
interest rate spread discussed above. Financials have yet to emerge from the penalty box of the ’08 crisis.

The markets seem bent on rallying to new all-time highs in the weeks ahead. Short-term momentum indicates they may reach that mark, but the long-term picture remains less than stellar with well below normal returns likely from both stocks and bonds. As a result, we remain fairly conservative in our investment philosophy realizing that preservation of capital may be more important than returns on investment to the end of the decade.

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.