Markets Poised For A Rest
One convention down, one more to go before the real fun begins of electing a President. The markets continue on their merry way, rising to new all-time highs supported by comments from the Central Banks that easy money is here to stay. But, what if the Wednesday Fed meeting contains verbiage that lets everyone know a rate increase is coming? Economic data is coming in better than expected. Inflation has picked up some. Global worries over Brexit seem to have subsided and the stock market is rising as though everything is just fine. This would seem to be a great opportunity for the Fed to hike rates, essentially pulling the punchbowl before the party really gets going. Our base case is the Fed does nothing, but we are entertaining the thought that just maybe the Fed is more willing to raise rates than we give them credit for today. Of course, politics may play a part in holding rates steady. The more cynical would believe rates stay put to ensure a growing economy at the elections to benefit Hillary. Trump supporters would say that that inaction would confirm “the fix is in” and only he could remedy the situation. One thing is for sure: there will be a few surprises before the election.
The trading from Brexit to today has been rather historic. Ahead of the vote, the markets were trading nearly two standard deviations above their 50-day average price. By Monday’s close, they were three standard deviations below. From there, they then moved to over two standard deviations above. The giant swings have not happened in the history of the markets and the move from Monday after Brexit to last week happened once before, at the market bottom in August 1982. So if you have a case of whipsaw, we understand! All that said we would expect to see some softness in the weeks ahead as investors digest much of the news. Sentiment readings are getting rather high as investors embrace this move higher. Historically, when sentiment gets this bullish at highs with short-term rates rising, there typically is a 2-3% breather that follows. The catalyst for that decline may indeed be the Fed meeting this week as investors are not prepared for a Fed that could be very willing to raise rates soon. Other short-term worries are the rise in the dollar and decline in energy prices. We saw both during the fall and winter last year that led to the decline at the start of the year. We do not expect a repeat, but it could be a reason to see at least a bit of a pull back in prices.
Looking at very short-term treasury rates, they have been inching higher and now stand at their highest point since the ’08 crisis. Long-term rates have declined; meaning the difference between the two is getting smaller. The last time the difference between short and long-term rates was this “small” was between ’05-’08 leading up to the crisis. The signal from the bond market is a worry that economic growth remains tepid and recession worries are growing. A definitive signal of a recession remains probably at least a year away based upon today’s data. The narrowing of the spread (now below two percentage points) indicates better performance from growth stocks vs. value. However, this signal has favored value for much of the past eight years when growth has dominated. Given the extraordinary monetary policies of the past decade, it is hard to say that things are working as they “normally” do, perhaps this is the new normal.
The various asset classes all remain strong relative to their long-term average prices. Even bonds continue to perform well as stocks hit all-time highs. As with many things in this market, normal is a hard thing to find. Emerging markets are beginning to show signs of leadership, even performing better than the SP500 and the other developed countries. The drawback to emerging markets is they tend to be very volatile, with plenty of periods when they have dropped by 10% or more over a three-month period. In absolute terms, prices have been in a 20% trading range from much of the past six years. However, when compared to the SP500, they have performed poorly for that period. That may be beginning to change. They bottomed at the start of the year, six weeks ahead of the SP500 and have steadily outperformed the US benchmark. As we have highlighted before, emerging markets remain the cheapest part of the equity market, selling for about a third less than the US with a dividend yield 50% higher.
The Fed comments later this week will be instructive as to their timeframe of increasing rates. While we think they stay on the sidelines through the year, the possibility is growing that they increase them sooner than later. The stronger dollar and weaker energy is also a concern, but we are seeing better opportunities overseas, specifically in emerging markets.
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.