An Economic Assesment for the Near-Future Term
As of the writing of this report, all the gains that we were enjoying year to date are now gone. In our ongoing effort to manage the downside risk in the comprehensive portfolios of our clients, we've outlined a plan to minimize losses in the face of what we believe will unfold in this uncertain market climate.
We are living in an environment of “6 D’s” that are depressing long-term US and global economic growth. These are:
Debt – The world is pushing the limits of debt at all levels. Debt has grown to levels such that debt service payments have started to take away from optimal investment into growth. Debt levels are at record highs for corporations, people, central banks and governments and continue to grow.
Deficits – Governments are continuing to operate with deficit spending and to finance it with more and more borrowing.
Demographics – Aging of population is increasing in all developed and many emerging economies leading to decreases in the number of working adults in proportion to overall population growth.
Demand – There is declining demand for goods and services due to aging demographics, income inequality and stagnating wage growth.
Disenchantment - Disillusioned populism leads to divisiveness which leads to political, social and possibly global turmoil.
Disruption – Rapid change in ongoing technological revolution is displacing people, businesses, healthcare, defense, security and governments while placing increasing amounts of information into sophisticated analysis methods to optimize decision making.
While why something is happening could always be debated, it is vastly more valuable to recognize what is happening, so here’s our view on what is going on now.
1) The current economic cycle has peaked and is beginning to decline. Eventually this should lead to the realization that the previous average market economic cycle growth rates of 3.5% to 4% is now at a lower “new normal” of 2% to 2.5%. This means the stock market may be 30% to 40% overvalued based on new lower future growth expectations. Please see the chart just below.
2) The Federal Reserve, our Central Bank, is raising interest rates back to more normalized levels given our regained economic market stability and the current achieved target inflation of 2%. The Fed is projecting another 0.25% (one quarter of one percent) rate hike in December and up to three more in 2019. This significantly increases the cost of money for everyone borrowing it, especially for short-term borrowers. This immediately and negatively affects current spending and decreases corporate profit margins as the cost to borrow funds increases. With the US Federal government operating at some of the highest deficits in history, our Government will need to borrow even more to finance its growing spending, pushing interest rates even higher.
3) The Yield Curve, which is the chart of interest rates being paid on the safest securities, US treasury bonds of different maturities, has partially inverted between 2 and 5 years and is the flattest it has been between 2 and 10-year lending rates in over 10 years. This stifles growth because it makes long-term lending unattractive. Lenders are unwilling to lend for riskier longer terms at rates of return that are same or below shorter-term lower-risk loans. When the 2 year to 10 year yield curve inverts, it has a perfect track record of forecasting a recession or negative economic growth. That is, a shrinking economy within 20 months on average.
4) Our trade-war with China, a communist-led superpower that is the second largest economy to US in the world is not a long-term situation that can be enforced to our benefit.
5) The UK is scheduled to exit the European Union in March, 2019, but has not been able to come up with its own plan or agreement on terms with EU. Again, stock markets hate uncertainty.
6) Strong US employment is leading to higher wage growth. This can cause declines in business profit margins, down from historically record high levels.
7) Economic growth has been declining all over the world in 2018. The US is the only developed nation that is still growing at a relatively robust pace, the result of massive corporate tax cuts and some personal tax cuts as well, but even US pace of growth is now declining faced with lower demand from slowing economies worldwide. We were largely disconnected sheltered effects of tax cuts but now this one-and-done effect is over in 2018 and no similar non-US government stimulus is coming to continue to artificially bolster the low organic economic growth rate which has not at all increased from its 2.5% despite all the anticipated effects from tax cuts. The US has not decoupled from the rest of the world and declining economic fundamentals are numerous and growing.
8) Lower profit margins and declining economic growth have led to second quarter’s peak corporate earnings and the beginning of a decline for this economic cycle. While still positive and relatively strong, it is highly likely that 2019 actual earnings will be below currently-forecasted 2019 earnings. This downward revision of expectations may lead to the associated downward repricing of assets and may follow with a further, currently unanticipated slowdown in 2019.
9) The Fed increasing interest rates should keep the US dollar strong verses other currencies, making US goods and services more expensive for current foreign purchasers, while the future potential decline from current high levels of the US dollar may lead to lower future investment returns for foreign investors, dampening their interest in investing in US. Lower demand may lead to declining US Gross Domestic (and National) Product, our output.
10) The Democrats have taken control of House of Representatives, leading to a split Government and spoiling the President’s “growth at any cost” agenda. Republican-led initiatives likely derailed and the increasing odds of Presidential impeachment should the shortly upcoming Muller report provide required evidence, is leading to increased political turmoil and Congressional inaction on further economic stimulus through fiscal government spending including infrastructure and other, as well as any further tax cuts.
So that’s the story. Now for some facts.
1) 90% of asset classes in the world are down for the year with US utility stocks as the single hold-out so far and only very slightly. Cash and high-quality short-term bonds held to maturity may turn out to be the best-performing assets for 2018.
2) Correlations are at historic highs and in the highly-synchronized global economy, everything is coming down together. Even within each asset class, the decline in price is very uniform with very little dispersion in return. This means that there is “nowhere to hide” during this seemingly “perfect negative storm”.
3) Volatility is still at historically average levels but is rising, and sudden volatility spikes have demonstrated the computer-traded nature of markets where selling causes more selling, liquidity disappears and there are no buyers.
4) A decade of super-low interest rates plus easy lending, fueled by the chase for yield, has very likely resulted in a “bubble” in low-quality loans and high-yield bonds. This may eventually result in much higher than historic 10% default rates once recession becomes evident and credit seizes. Higher interest rates from the Fed have increased the cost of borrowing and might be the needle that pricks this bubble. This will likely dislodge capital markets with spillover effect into all risk investments, as well as the rest of the overall economy, potentially leading to or at least accelerating a recession. Credit spreads for higher risk loans, or premium higher interest rates over safer loans, have already begun to expand.
5) The US stock market as illustrated by the S&P 500 has broken its long-term growth trend and the previous leaders, the technology high flyers such as Facebook, Apple, Amazon, Netflix and Google, the so called “FAANG” stocks, have led the downturn, tumbling the most. The change of market leadership from cyclical and growth stocks, such as technology and consumer discretionary, to defensive sectors such as utilities, healthcare and consumer staples is further evidence of increasing risk-off positioning by large institutional investors.
So what to do?
Here is where we have done and plan to do:
1. Using the S&P 500 index ETF (“SPY”) as a proxy for the S&P 500 index, this US stock index has peaked at 293.94. As of 12/21/2018, SPY is at approximately 244, for a decline from peak of 17%. This is larger than the 10% decline that is typically used to define a market correction.
2. As of the writing of this report, we are 11% below the 200-day Moving Average of SPY which is now at 275.45. This fact is commonly used to identify a long-term trend in this Index, and this is what caused us to recommend a reduction in all stock market allocations by 25% over the last 30 days. vi
3. SPY has declined and is holding its decline by more than 12% off the peak SPY index value. We are now reducing fee-based clients’ stock market portfolio investments by another 25%.
4. In the event that the stock market continues to decline rather than stabilize, once the S&P 500 ETF “SPY” declines 10% below its moving average of 276.11 to approximately 243, or its slope turns downward even sooner, we will reduce all participating clients’ stock market allocations by an additional 25%. This will leave clients exposure at 25% of target allocation, 75% below their stable market allocation, substantially reducing risk in participating clients’ stock market portfolios.
In the event that your cash position is increased, the result of our actions, how will we then invest this “cash money”?
1. Short-term US Treasuries to serve as safe harbor investments during periods of market weakness.
2. High-quality, low-duration (4 to 6 year average weighted maturity) corporate and municipal bonds.
3. Gold and private real estate, such as the Blackstone REIT.
Last but not least, we are hoping for a typical end-of-year bounce to materialize in the December to February time frame, especially if Fed feels pressured by increasingly negative economic data, the markets, the President or all of the above, and communicates a more cautious and data-dependent tone for their future rate increases into 2019. The year-end and year beginning bounce typically happens because private investors can finally estimate their earnings and maximize their contributions to retirement plans, and also because professional managers want to put more money to work in the markets so as not to appear as they are charging fees on large amounts of cash.
Our risk-attentive approach focused on capital preservation and growth across the entire market cycle from market peak to market peak has the goal of PFS delivering to fee-based money management clients lower risk/lower volatility returns that are necessary for long term wealth accumulation and income generation. As always, our main goal is to help you achieve your long-term retirement planning and income goals, not just to hit a target rate of return.
These are our thoughts, plans and actions, and as always, we want to remind you that we don’t invest to be right, but to first preserve and then grow your wealth. This includes not only striving to adapt to meaningful changes on a timely basis, but more importantly to make more when we are right and lose less when we are wrong. It’s not just the tortoise but a smart tortoise who knows when to vary its pace that wins the race. In this case, utilizing a vigilant, insightful and disciplined approach, designed to eliminate “knee-jerk” reactions that are likely to result in poor long-term decisions.
It is always easier to deliver good news than bad news. Sorry for this report so close to the Holiday Season. But, the truth is always better than a white-washed lie or story that is designed to make someone feel better, but still results in negative outcomes.
We will be holding a series of webinar conference calls over the next week to further share our thoughts and position on the world markets. We will share the dates and times with you over the very near term.
We are taking these actions for fee-based clients only. You are a fee-based client if your Securities America/National Financial Services, Inc. account number starts with AEL, AEW, AE0 and AE2. If you have a commission account, your account number will begin with “SGH”. If you are a commission account client, please call us at your convenience.