Client Letter - Playing Musical Chairs with the FedSubmitted by Alsworth Capital Management, LLC on July 22nd, 2019
Second Quarter 2019 – Playing Musical Chairs with the Fed
All asset classes rose during the second quarter, as progress in U.S.-China trade negotiations and a newly dovish Federal Reserve buoyed investors. The S&P 500 index of US stocks hit a new high near the end of June. Large-cap U.S. stocks shot up 7.0% for the second quarter, and a remarkable 18.5% for the first half of the year. Although emerging markets stocks were only up 0.8% for the second quarter, their first half gains stand at 12.6%.
Fixed income (bonds) also gained, as the 10-year Treasury yield fell below 2.0% on the heels of the Fed’s willingness to cut, rather than raise rates at their June meeting. When bond yields fall, their prices rise. The core bond index gained 3.0% for the quarter and 6.1% year-to-date. Floating-rate loans gained 1.7% for the quarter and 5.7% for the year.
Alternative investments also gained. The trend-following managed futures funds we use remained in positive territory, building on a positive first quarter.
In the fourth quarter of 2018 early signs of an economic slowdown, coupled with fears that the Fed was raising interest rates back toward more normal levels too quickly, caused the stock market to sell off 20% abruptly from a high of 2,930 on the S&P 500 Index in September, down to a low of 2,351 in December. Fearing a spillover effect on the economy from a steep market decline, the Fed reversed course and started publicly talking about potentially lowering interest rates. This calmed market fears and sent the stock market shooting to new highs, fully recovering to 2,941 on July 28th, slightly higher than the September 2018 highs. So, we are basically back where we started. The 20% decline was fully recovered before most investors were even aware that it happened. The single most important factor in the recent market movements has been Fed policy. It has been more important than corporate earnings, escalating tensions with Iran, tariff wars, impeachment votes or even the impending debt ceiling debates.
The US economy has been on a slow recovery since the Great Recession of 2008, averaging GDP growth of 2.4% per year from the low point to today. This is one of the longest recovery periods in history, but it also has the lowest growth rate, well below the historical average of 4.4% annualized GDP growth in expansion phases. The recovery has been substantially aided by unprecedented fiscal and monetary stimulus that has also, unfortunately, resulted in an explosion of our national debt to over $22 trillion and counting. We are on pace to add well over $1 trillion to the national debt each year, with that pace dramatically accelerated after the 2018 Tax Cut & Jobs Act, that resulted in lower corporate and individual tax receipts. Stimulus has helped push up current economic growth (borrowed from the future through debt that must be paid back), however, there are clear signs now of the economy slowing back down toward the 2% GDP rate. This slow-down has caused many economists to warn of recession and demands for the Federal Reserve to bail us out through lower interest rates have persisted.
When the Fed lowers interest rates it allows investors to borrow cheaply and hopefully spur economic growth. It also allows companies that carry high debt levels to continue to extend their debts out to longer and longer terms and continue to pay on the borrowings more easily. This is good when companies are responsibly managing their debts and not over-overextending. However, it can also create conditions for excessive leveraging (borrowing), which becomes problematic when interest rates rise to more normal levels. This bears watching, since we are at a crossroads where the Fed needs to get rates up to a point that they can cut them meaningfully during or preceding a recession to help stimulate the economy. Otherwise, we will be caught without any ammo in the next downturn.
Stock Markets & The Fed
Conservative (and typically older) savers that are putting money away in yield driven investments like bonds and money market savings are hindered by low interest rate policies and they are driven to take on riskier investments to earn a reasonable return. This has the positive impact of providing investment funds for innovative riskier ventures. However, the longer it persists, investors get lulled into misjudging risk and their own tolerance for accepting the inevitable downside periods of investing. By pushing investors into riskier investments, the Fed has pushed the price of these investments well above their intrinsic fundamental value and investors have been forced to accept the higher risk. It’s like musical chairs. Everyone enjoys dancing until the music stops. The timing of when the music stops or exactly what will trigger it are not predictable. However, history suggests that it always does. Paying high prices relative to fundaments has always led to those excess “gains” being wiped out in abrupt adjustments. Unfortunately, timing when to sit down versus keep dancing is impossible to do perfectly and it’s very difficult to even guess close to correct. Our strategy has always been to recognize periods of over-valuation and excessive risk taking and migrate toward the closest chair slowly. By doing so, we hope to continue to participate in the dance, yet be closer to the chair when the music stops so that we can survive to play the next round.
Recovering quickly from the recent 20% sell off in stocks has provided us with an opportunity to reassess our allocations in light of changing investor sentiment. While we are not forecasting an imminent recession or drop off in corporate profitability, we are seeing a shift in how investors are reacting to news. As is typical in conditions of high valuations, volatility is here again with bigger more abrupt price swings. We will be making small shifts in the portfolio to reduce stock allocations in the coming weeks. This is not a big move, but instead just inching closer to a stable looking chair as we continue to dance.
As always, we appreciate the trust you place in us. Please reach out to setup an appointment if you would like to review your portfolio or update your financial plan.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Investments are subject to market risks including the potential loss of principal invested.
Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, Litman Gregory Research