Summer Lull

If you slipped into a coma on August 1st and just regained consciousness on August 31st, you might have looked around and thought that you really didn’t miss much while you were out cold.  The world’s capital markets were sitting right about where they started.  The S&P 500 traded in a very narrow range with market volatility subsiding to near multi-year lows amid the traditionally slow summer vacation season, but there’s more to the story. Sure, Congress wasn’t in session (which is good, right?), and most of continental Europe seems to take all of August off every year anyway, but seasoned market watchers know that a lull in volatility like we’ve seen recently can’t last forever. After the Labor Day holiday, Wall Street traders will come back to work which should help trading volume pick up, and you can be sure that politicians and central bankers will return with their “fixes” for problems that didn’t just go away during a ho-hum final month of the summer.

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THE ECONOMY

The latest batch of U.S. economic data isn’t great, but it also doesn’t appear to point to an imminent recession. The economy is growing, but just barely. The latest estimate of GDP growth shows the economy was slightly weaker in the spring than initially thought. GDP expanded at an annual rate of 1.1% in the second quarter, down from a late July estimate of 1.2% – a number that was already far below consensus expectations when it posted. However, consumer confidence has firmed, due in part to continued improvement in the labor market, and wages that are finally starting to rise. Housing looks okay as well. Additionally, revolving consumer credit and bank loans are on the rise, indicating consumers may be more comfortable taking on debt. Unfortunately, business confidence remains subdued, reflected in weak productivity. A contributing factor to weak productivity is undoubtedly ongoing tepid capital spending due to lackluster small business optimism. In other markets, Eurozone confidence edged lower in August, suggesting the Brexit vote has started to take its toll on the single currency bloc. Now the European Central Bank (ECB) can add to its case for more stimulus to sustain the recovery and revive inflation, currently stuck at 0.2% in August. Other data released by Eurostat showed the bloc’s unemployment rate unchanged at 10.1% (more than double the U.S.). The figures could push the ECB to launch additional stimulus as early as its next policy meeting on Sept. 8, which could involve extending the duration of its bond-buying program by at least another six months. Growth is at an absolute standstill in Japan. Second quarter GDP came in at 0.2% annualized as the extraordinarily stimulative policies of Japanese Prime Minister Shinzo Abe have failed to achieve liftoff.

In contrast to the developed world, emerging markets (EM) have had an active summer for several reasons. Aside from the potential for tighter global financial conditions and fading optimism on the strength of recoveries in Brazil and Russia, the rebounding growth momentum in China may soon begin to fade. Much of the fear that weighed on EM performance last year was derived from the risk of a sharp economic slowdown, or “hard landing,” in China. After China’s manufacturing PMI in 2015 hit the lowest levels since the 2008-2009 global financial crisis, it rebounded to near the highs of the five-year range. This suggests that the momentum that has lifted EM stocks may soon begin to fade.

Central Banks

Readers of this newsletter know that central bank policy, in the U.S. and around the world, has been a major focus for several years now. Global central bank policies demand attention because of their scope and scale.  The scope was massive: to save the global economy and prevent the collapse of financial markets.  The scale of policy implemented has been largely unprecedented, with central bank balance sheets larger now than they have ever been before. Their continued experimentation with old and newly devised monetary tools is an unrelenting effort to spur economic growth, encourage spending, stimulate lending and force savers to put their money at risk in the markets. Will it work? We’ll see. One way to evaluate monetary policy decisions is to consider whether they encourage or discourage growth. The U.S. central bank, our Fed, is desperate to get the economy growing like it did pre-crisis. The average growth rate of the U.S. economy over the last 50 years (through 6/30/16) has been +2.8% per quarter (i.e., quarter-over-quarter change expressed as an annualized result), but every quarter since October 2014 has reported less than +2.8% growth. (Source: DOL). Recent growth has obviously been below average. That’s what the Fed says it’s trying to fix. But can it? Should it? We know this: whether intended or not, central bank policies have been very effective in creating asset price inflation in stocks, bonds, and real estate. For almost a decade now central banks around the world have unleashed round after round of quantitative easing (QE), zero interest rate policies (ZIRP), and most recently negative interest rate policies (NIRP). The Fed hasn’t waded into the NIRP waters, at least not yet, but we may be heading that way. FOMC Chair Janet Yellen said late last year that negative interest rate policies weren’t off the table, and just last week FOMC Vice Chair Stanley Fischer endorsed the use of negative rates in other economies and thinks they have helped. The Fed has acknowledged that they required banks to include the possibility of negatively yielding Treasury rates in recent stress tests, so we know they’re getting help evaluating the possible impact of negative rates. Maybe what was once thought unthinkable in the U.S. is actually on the horizon? Negative rates may seem to work for central bankers, but they can be devastating to large swaths of investors like retirees, savers and people who need income from traditionally less risky assets like bonds.

Capital Markets

Over the long haul, markets are driven primarily by three factors: earnings, valuations, and central bank policy. In the wake of the global financial crisis and the Great Recession that followed, the influence of central bank policy (see above) has been pushed to the top of that list of factors. Earnings growth in recent quarters has been less than stellar but is expected to improve over the next year or so, largely in part due to the U.S. consumer. The Price-Earnings ratio of the S&P 500 sits right at its long-term average, so stocks can no longer be considered cheap. But because bond yields are so low right now, the higher earnings yield found in the stock market has attracted a lot of otherwise income-oriented investors, which means stocks may still push higher. A caveat to the earnings yield found in stocks right now is in order, though. According to FactSet, dividend payouts at S&P 500 companies for the past 12 months amounted to almost 38% of their net income over the period, the most since February 2009. This level of payout is unsustainable in the long run, and something will have to give. Net income will have to increase for these dividends to remain in play, or dividends will need to be cut.  The major U.S.stock market indices pushed to new highs in August following the sharp selloff after the Brexit vote in the U.K. in July. According to Ned Davis Research, investor sentiment is neutral right now, and longer term sentiment remains relatively pessimistic. Additionally, investors have pulled $95 billion out of U.S. equity mutual funds and exchange-traded funds (ETFs) this year. These close to record outflows means there is continued doubt out there among investors, which is actually a healthy sign for the markets. Remember, investor sentiment tends to work in a contrarian fashion to the markets. Euphoric investor sentiment is a big indicator that the markets have gotten ahead of themselves.

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This summer has been especially hot for emerging market stocks, which lagged developed markets in 2015 and got off to a cold start in 2016. As of mid-May, the MSCI EM Index was flat for 2016 but has since posted more than a 13% gain for the year through the end of August, relative to just a 5% gain for developed market stocks as tracked by the MSCI World Index.

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Interesting Times

There’s an old saying: “May you live in interesting times.” Tradition has it that its origins are Chinese, but no one knows for sure. We live in an age with so much exciting potential, and also one that seems fraught with its fair shares of perils. The world of transportation is experiencing huge changes. Automated cars and drones that will deliver packages, and at some point people, are right around the corner. The technology is already here. Now engineers and lawmakers just need to work out the details. Even automated ships are coming, which really makes more sense than automated cars. Honestly, could there be anything more mind-numbing than sailing a cargo ship across the Pacific Ocean?

Ship designers, their operators, and regulators are already gearing up for a future in which cargo vessels sail the oceans autonomously with minimal or even no crew. Experts claim unmanned shipping could cut transport costs by 22%. The retailing world is experiencing huge changes as well. E-commerce sales increased 24% in just the last year and now account for 9% of all retail spending. No wonder so many department store malls are going out of business.

Conversely, our world is threatened by the harmful effects of unsustainable debt levels and global terrorism, among other concerns. According to the Congressional Budget Office, our national debt now stands at $19.5 trillion and is projected to reach $28.2 trillion as of the end of fiscal year 2026, only ten years from now. It was less than $10 trillion a decade ago. The war on global terror costs the U.S. an estimated $100 billion each year on average, and even more in the toll taken in lives lost and damaged. The world is a dangerous, risky, and yet exciting place. A prudent investor is wise to evaluate those risks carefully and have a plan in place for whatever the world may throw at him. Interesting times indeed ….