Capital Market Comment
February 6, 2018
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
The resiliency of the equity market in January surprised many, particularly following the strong Q4, 2017. Now, the recent rise in interest rates and the swift reaction in the equity market punctured a great deal of enthusiasm and quickly spawned talk of a correction. “How quickly they turn.” It should be of little surprise to investors that interest rates will rise in an improving worldwide economy. However, it is important to note that few financial advisors have experienced a rising rate environment. Consequently, it could cause spastic responses by inexperienced “professionals.” More importantly, many algorithms and quant models have similar characteristics and thus move in the same direction (the herd). Shifting psychology in a world of numerous derivative products with mindless computers and robo-investing can create dysfunctional markets (flash crashes).
Having been an active advisor in the investment business during the rising interest rates of the 1970s and 1980s when rates reached near 16% for the 10-year Treasury and hit 21% for the prime rate, a different mindset emerges. The eroding values of long-term bond portfolios become problematic for many advisors and investors alike, and the equity portion needs to be viewed in a different light. Equities take on the characteristics of an “inflation” hedge particularly if rising rates reflect changing inflation expectations. This change does not happen overnight. It is important to recognize that secularly rising rates (higher highs and higher lows) occur over many decades and are accompanied by many interim cycles of rising and falling rates.
The sudden shift in sentiment, precipitated in part by momentum investors, algorithms, and quant models, should provide a basis for refocusing upon the fundamentals and away from “momentum chasing.” Bitcoin is an example of what can take place when a frenzy takes hold with little understanding and/or regard for the fundamentals.
Stepping back from the short-term volatility that has engulfed the equity market in February, the fundamentals suggest that the floor under the equity market has been raised.
As we suggested in our December 20th Capital Market Comment, the corporate tax cut could cause a step-up in earnings of 7-9%. It appears that the impact could be greater. Moreover, to the extent that the tax cut stimulates growth (consumer, etc.), the accelerator principle is likely to come into play. This economic concept suggests that if the demand for consumer goods increases, then the demand for capital goods (machines, etc.) will increase even faster.
At the same time, the downward trend in the dollar that has persisted for over a year is providing tailwinds to the earnings of multinational corporations. This trend is occurring at a time that economic growth overseas is accelerating (Europe, Japan, etc.) with world growth being estimated to be approximately 3.8% in 2018.
The combination of these two developments and a reduced corporate tax rate to 21% from 35% provide a relatively long runway for revenue and earnings growth. However, against this business backdrop, the financial landscape is undergoing a transition. Interest rates which are responding to the improving economic condition around the globe have been rising. The 10-year Treasury has risen from 2.4% to 2.85% (45 basis points) over the last month. Furthermore, the German 10-year Bond moved from 40 basis points to 80 basis points in the same period. The changing rate environment is weighting upon equities in early February. There may be a growing realization that the direction of interest rates may have truly changed, and investors are trying to grasp its implication.
Although the level of rates is still quite low and thus the rate at which earnings are being discounted are only being minimally impacted, it is the change and speed of the change that is impacting market participants in the short-term.
Another element that is being reassessed by market participants is Federal Reserve policy. The continued strength in the economy reflected in jobs growth and an uptick in wage gains has increased the probability that rates will be increased three times this year. Some are even suggesting four increases. Market volatility will not go unnoticed in the halls of the Central Banks and may well influence rate decisions.
Many factors will come into play in setting policy. However, short-term rates remaining below the inflation rate seems likely to persist into 2019 given the expected inflation rates and the pattern of rate increases. Moreover, Europe remains committed to maintaining monetary accommodation. The near-term appears to be held hostage by the quants, but the longer-term will benefit the investor.
Mastrapasqua Asset Management, Inc. does business as M Capital Advisors. If you have a question or need further information, please contact:
Patrick Snell, CFA, Principal & Portfolio Manager in Nashville at 615-244-8400, or firstname.lastname@example.org or
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or email@example.com.
© 2018 Mastrapasqua Asset Management, Inc. All rights reserved.
The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.