The Fed & Brexit

PaulNolte-2Will they or won’t they? There has been way too much hand-wringing about if/when the Fed will raise rates this week at their meeting. It has been assumed they would likely hold off until July if only to allow the British vote on staying in the European Union on the 23rd to be “free” of outside turmoil. All that said, the Fed governors have been rather vocal while on the speaking circuit that a rate hike is very likely sooner than later. The betting by Wall Street is a pass in June and a strong “maybe” in July.

Lost in the rhetoric has been a continued plunge in global interest rates, with ALL sovereign debt in Germany now trading with a negative yield out to 10 years. Two years ago it was thought that negative yields could only occur in times of stress. Today, there is over $5 trillion in just government debt with a yield less than zero. What is not understood are the long-term implications of negative rates, and more importantly, when rates will once again rise to more “normal” levels. Can one central bank raise rates in the face of a global negative rate environment? The unintended consequences of a negative rate policy are likely to be felt for decades and in ways we can only guess at today.

In what is sounding like a Tony Orlando song, the SP500 has knocked on 2100 at least three times since late last year. As investors fret about the Fed, Brexit and economic data that are not supportive of higher rates, stocks have struggled to
make headway at 2100. We have harped upon the lack of earnings over the past two years as the main culprit holding
stocks back from further advances. Expectations are for a better than 15% gain in earnings over the next six months vs.
late 2015, which seems a rather high hurdle without much economic growth. The latest GDP report indicated growth is
running just below 1% and indications from the Atlanta Fed are for growth to “jump” to 2.5% when the current quarter is
reported later in July. The argument for stocks is still based upon a comparison to bond yields. With rates near zero,
plenty of stocks provide yields well above that on bonds, so investors need to buy stocks to gain a return. What is
forgotten with this argument is that stocks can decline, and dramatically so, more than bonds, easily wiping out any
nominal gain from higher dividends. Finally, intermediate government bonds have matched the SP500 for total returns
since late 2014, without all the excitement of the big drops experienced over the past nine months.

As the European Central Bank begins buying corporate bonds as part of their efforts to jump start their economy, interest
rates around the globe continue to fall. Investors knowing they will be “backstopped” by central banks are very willing to
take on risks well beyond what would be considered normal. Interest rates continue to fall globally, keeping the bond
model solidly in bullish territory and indicating the rate slide is still not finished. For US investors, international bonds are
once again looking interesting as the dollar has stopped rising. Returns on many “risk” assets, from emerging market
bonds, to US junk bonds have soared since the market bottom in February. At some point the party will end, and it could
end badly as default rates pick up due to lack of cash flow to cover debt service. Not an issue for high quality corporate
bonds, but much more so for those on the risky side of town.

When looking at the returns for various asset classes this year, a few things stick out. First anything with a dividend yield
has been bid higher. Utility stocks, the mundane “little old lady” investments, are up over 15% already this year.
Government bonds from 7 year maturities and longer are up over 5%, while the 30 year bonds are up over 10%. Former
darlings, healthcare and technology sectors continue to struggle to find interest. After hitting the skids last summer,
energy stocks have made it to one of the better performing sectors this year as well. With many major oil companies
sporting well above average dividends, this group may provide some good returns if energy prices can stay around or
above $50 per barrel. However, if global growth continues to show weakness, energy prices could easily fall back to
below $30/bbl before year end. The best way to “play” the market continues to be cautiously. The large US companies that
have products to weather thick and thin are likely to hold up reasonably well, while others that are not as financially strong
could see large price drops if economic growth fails to improve.

This week will be all about the Fed meeting and the press conference that follows. We think they hold off this month due
to worries about the vote in England, but they are likely to set the stage for a rate increase in July. This, of course, only
holds if the economic data shows enough strength to justify the increase.

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.