July Investment Comments
After ten years of mostly steady expansion, the industrial economy currently looks tired. Transportation, energy, and basic materials stocks have been among the market’s worst performers in the past one and three months. The statistics confirm investors’ concerns. April’s industrial production estimate showed annualized growth of less than 1%, about half its previous pace. In May, the manufacturing Purchasing Managers’ Index (PMI) logged its worst monthly reading since 2009. Statistics are noisy estimators, but it would be nearly impossible to generate data that bad purely by chance.
Yet non-industrial indicators continue to hold up. Retail sales and consumer spending are advancing steadily. Consumer confidence, surveyed by the University of Michigan, remains strong. Measured unemployment is just 3.6%. A slowdown in the economy’s industrial “engine” would have signaled a wider recession historically, but the industrial cycle just doesn’t seem to matter like it once did. The American worker and consumer is doing just fine thanks, steel or no steel.
And then there is the Federal Reserve, whose accommodative monetary policy puts a new, friendlier spin on the old saying that the government is always your silent partner in business. Just a few months ago, it was widely expected that in 2019 the Fed would continue to boost interest rates, withdrawing its longstanding subsidy to borrowers and reinjecting some discipline back into capital markets. That idea suddenly seems almost quaint. The bond market has not only stopped handicapping increases but has turned around to predicting outright cuts, possibly as many as four 0.25% cuts within the next twelve months.
So what changed? For one thing, measured inflation fell below the 2% rate that the Fed has come to view as neutral. Annual CPI (Consumer Price Index) inflation declined to 1.8% in the Bureau of Labor Statistic’s May reading. More importantly, long-term rates have plummeted, flattening the yield curve. 30-year Treasuries paid almost 3.5% in October but today yield just a little more than 2.5%. 10-year Treasuries yield a little more than 2%, which is less than the Federal Funds target rate currently. With inflation low and an apparent glut of undemanding lenders willing to trade any chance of capital appreciation for the safety of sovereign debt, it makes sense for the Fed to find excuses to cut rates.
Alan Greenspan stated his belief that the Fed’s power was limited to controlling short-term interest rates, with long-term rates determined by global forces. This may well have been true when Greenspan left office in 2006, but since then numerous rounds of Quantitative Easing have made central banks worldwide key participants in the market throughout the yield curve.
Like industrial stocks broadly, the housing sector had been looking a little tired lately. However, it responded to the interest rate drop with verve. In May, mortgage applications logged their biggest increase since early 2015. Lumber prices shot higher in June, presumably anticipating a resurgent demand for new building.
Gold has taken notice of the sudden snapback toward easy money, rising about 5% in the last month and retesting the highs it has visited periodically since 2013. Copper and silver are not showing nearly as much life. These are considered industrial metals, copper especially.
The world economy is mixed. The Euro area remains a little stunted, reporting 1.2% annualized GDP growth in the most recent estimate according to Trading Economics (www.tradingeconomics.com). For all its political discomfort, the United Kingdom’s GDP accelerated slightly to 1.8%. Japan’s 0.9% growth rate has been typical for that country over the past thirty-plus years. China, the main subject of President Trump’s trade imbalance ire, continues to report a growth rate above 6%, but this is at the very low end of the range it has been reporting since the mid 1990’s.
The U.S. dollar remains strong, having made gains against all major currencies except the Japanese yen over the past 12 months. Intuitively, fiat currencies should lose out to hard assets in a world where economic expansion relies on eternal easy money. That said, the dollar still looks like the “cleanest dirty shirt” amongst those currencies.
Speaking of hard assets, stocks have rapidly recovered almost their entire decline from May. Further gains may rest on the uncertain outcome of the impending Q2 earnings season. Analysts are not very enthusiastic. According to the most recent Earnings Insight, authored by FactSet’s John Butters, S&P 500 companies anticipate aggregate earnings to decline 2.5% year-over-year. The good news for growth investors is that these declines will be highly concentrated in the materials sector. The other trouble sector is technology, where the trade war’s supply chain disruptions will be the most acute.
Stock prices can be decomposed into an earnings component and a valuation component. Valuations are affected by interest rates and global macroeconomic forces. The earnings component is specific to the company, however, and we always advocate for companies with the ability to grow earnings and, over the long run, to effectively write their own ticket to stock price appreciation.
Miles Putnam, CFA