FINANCIAL QUAGMIRE OR FOGGY VEIL

Capital Market Comment
September 07, 2018
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer

As the markets wrestle with the forces and counter forces that are articulated daily in the media (trade conflicts, Iran, Russia, political turmoil, etc.), one wonders how to invest in such a financial quagmire. Is it really a financial quagmire or just a foggy veil which disguises the strong foundation that prevails under our financial markets? Most certainly, day to day volatility is heavily influenced by the news flow (if you want to call it that). This flow will continue indefinitely! Sorting through what is valuable input, or just the need to entertain and fill time, can be problematic. The headlines appear so daunting on many occasions that the “fear” emotion may be triggered, and poor decisions are made.

Often it makes great sense to step back and focus upon the structural and fundamental factors that drive markets and not the emotional ranting and ravings of talking heads, politicians, and the stream of worthless forecasters. Despite predictions to the contrary, interest rates, a primary force in equity market valuation, remains remarkably tame. The 10-year Treasury has yet to achieve a sustainable 3% level. Every move has been followed by the rate falling back to the 2.85% area. This drop has occurred even though economic growth exceeded 4% (SAAR) in Q2 and will likely exceed 3% in Q3. In fact, the Atlanta Fed is forecasting a 4+% rate. Also, inflation has up-ticked and is running at a 2-2.5% rate, depending on the measure you choose.

Despite the flood of government bonds coming to market to finance the deficit and the unwinding of Treasury positions by China and Russia, the stability of the 10-year rate is in part being influenced by other factors.

From our perspective, the relationship between the U.S. Treasury 10-year rate relative to the 10-year German bond is a particularly important. A 2.94% vs. 0.38% or 250+ basis point spread is a strong incentive to invest fixed income funds (on a worldwide basis) into the U.S. markets. The excess flow of international savings appears to be a factor. Moreover, the stability of the U.S. dollar and sometimes its strength, provides a safe haven in a world of currency instability – Argentina, Brazil, China, Russia, Turkey, etc. This yield relationship is consistent with “a bull market” in equities.

The credit markets often provide a window into the prospects for the economy and the equity market. The yield differential between low-grade (junk bonds) and the 10-year Treasury suggests liquidity conditions are constructive for both. The St. Louis Federal Reserve’s Financial Stress Index has yet to give any indication that problems are looming.

Another structural component that has been a characteristic of this bull market is the persistence of a net liquidation of equities for non-financial corporations. For more than a decade, the supply of stocks has been declining due to stock buybacks, mergers, and acquisitions. Despite what some pundits say, corporations are finding current valuations adequate to continue their buying programs. Furthermore, the explosive rise in earnings is impressive. S&P 500 earnings are up 25% in Q2 and projected to rise between 25-30% in Q3. Based upon the 12-month earnings estimate, the earnings yield on the S&P 500 is near 6%, more than double the yield on the 10-year Treasury Bond.

Most certainly, the tax cut is playing a significant role in the earnings performance as well as in giving shareholders a greater percentage of ownership. These factors, as well as the strength in the overall economy as evidenced by employment growth and the ISM Surveys, solidify the underpinning of the equity market.

Overseas uncertainties remain and the Federal Reserve’s continual effort to normalize rates are market constraints. The next Federal Open Market Committee meeting on the 25th and 26th of September is very likely to generate another rate increase in the Federal Funds Rate to 2% or 2.25%. Although the rate will remain below the inflation rate, the spread is quite small. Subsequent increases that may be forthcoming could begin to become problematic. Additionally, the shape of the yield curve is likely to become an even greater source of debate. Many Federal Reserve representatives are concerned that the monetary authorities will become the source of a yield curve inversion. We are not there yet, but the risk exists. The gradual path the Fed has chosen seems manageable, but any change in the upward speed of the adjustment could change the market dynamics.

September and October are interesting months in the lore of stock market history. Some of the worst and best market action has occurred in those months. However, the subsequent period is generally constructive. At this juncture, any market volatility should be viewed as an opportunity.