Economic and Market Forecasts
Economic and Market Commentary, August 2017
RATES ARE RISING: THE KEY IS HOW FAST
These forward-looking forecasts are an integral part of our tactical investment process. Instead of using a buy-and-hold strategy, we understand that risk changes over time, and we make ongoing, tactical changes to our portfolios to consistently move away from risk and toward opportunities. These changes are based in large part on the forecasts enclosed, which are generated from continually monitoring current and historical data and then forecasting future conditions of domestic and global economies and markets.
Interest rates are on everyone’s lips. With the Federal Reserve finally kicking off steady rate increases, the critical factor becomes the speed of those upticks. Too fast and we could find ourselves in a recession, caused by dampened business earnings and consumer spending, or, possibly worse, a fast sell-out in bond markets.
Foreign banks have taken a cue from the Fed and have begun to increase their rates; luckily, demand for income-producing assets has kept bond prices strong even with global rates rising.
The key for the Fed is to balance rate changes with its need to sell off assets (those purchased in the recovery)—all while fueling an economic expansion. No short order. A slow-rate environment is essential for just about everyone. It would result in further stock-price improvement and—more importantly— less risk in our bond positions.
In equities, the U.S. market continues to shatter ceilings. The good news: in a low-rate setting its prices are relatively cheap compared to previous market highs. And, as we’ve written for several quarters, there are still key economic factors that can fuel equities through 2017, including strong corporate earnings, expected wage growth, and no indication of an economic slowdown.
Our attention is also turned overseas. Japan and several of the Pacific Rim emerging markets, including China, continue to show signs of momentum and hold attractive valuations.
EFFECTS OF RISING RATES ON BONDS
We’re closing in on the 36th anniversary of a bull run in bonds—and we’re likely near its end. At this point, it’s not so much a matter of if rates will rise, but how quickly. The key now becomes which bonds you’re holding as rates increase.
Different classes of bonds react very differently to rate changes. Traditional bonds, such as 30-year Treasurys (ones that most bond investors own), are extremely rate sensitive. With every 1% increase in rates, they can lose 17% of their principal1. Should higher rates sustain, the principal is gone forever. These and other traditional bonds are now riskier than ever in our lifetime. On the flip side, there are bond classes that perform well with rising rates. It's now critical to review your bond portfolio with your advisor.
The rate of interest rate increases is key.
Rates are increasing in several major markets, including the U.S. The expected slow-rate of increases will bode well for reducing bond risk.
Overall, equities have a slight advantage over bonds. Though we don't think there are massive opportunities for equity-value growth, bonds will surely experience a slight disadvantage from interest-rate increases this year. Additionally, opportunities are arising in certain foreign equity markets.
Due to relatively high prices, U.S. equities may be close to an inflection point, where they will underperform against their foreign peers. Though the S&P 500 remains at an all-time high, in our low interest-rate environment the market is still relatively cheap compared to the last two peaks (2000 and 2007). Additionally, market volatility remains low. The volatility index VIX, which projects volatility over the next 30 days, is currently 9.8—well below its 10-year average and its 2008 peak of 80.91.
U.S. stocks should continue to be fueled by favorable economic news and corporate earnings reports. If earnings stay strong, as they are forecasted, there’s not a huge risk of a market correction. Strong earnings will point to a continued growing economy and reasonable stock-price valuations.
Internationally, earnings and economic growth in Japan and Asian emerging markets continue to look stronger.
After a decade with only one uptick, rising rates are likely our new norm. The pace of increases and its effect on the economy becomes critical, as rising rates can add costs to businesses and create a drag on consumer spending, which comprises nearly 70%1 of our GDP.
Global banks have followed the Federal Reserve’s lead and taken their first substantial rate hikes, and foreign rates are likely to move faster than domestic ones. Bond prices should stay strong, even with global rates rising, as long as demand for bonds continues and the Fed moderates subsequent rate hikes.
Also at play is the need for the Fed to begin selling assets—including the bonds they purchased during the recent recession (during Quantitative Easing). These sales have the propensity to drive bond prices down, resulting in rates rising more sharply than they do when adjusted directly by the Fed. The Fed’s actions are key here. Any sale of assets would be absorbed more easily in a strong economic and slow rising-rate environment. If sold too quickly, and combined with rising rates, it could push us into a very fast rising-rate environment, which could lead to recession.
A slow rising-rate environment is better for the economy and the markets.
With the rebound in certain emerging-market economies, the credit quality and risk factors of emerging-market debt is improving, and we’re considering these against domestic high yield.
Near term, energy will likely stay in its current trading range, versus being driven by the supply-demand curve. REIT prices have yet to rebound after their 2016 year-end decline, making them attractive relative to the S&P 500. REITs also possess potential inflation-hedging benefits, which haven’t yet been important but could be as rates and wages rise. On the flipside, there’s a growing concern regarding commercial retail space.
Continued Economic Expansion
A growing, healthy economy often sets the stage for corporate growth, expected future earnings, and growing stock values. In analyzing the economy, we project the outlook for various types of stocks and bonds, then reduce asset classes with more projected risk while favoring those with projected opportunities.
Domestic economic strength will likely continue through 2017—backed by heightened business investment spending, anticipated wage growth, and proposed tax cuts and business-friendly regulation changes. This should paint a backdrop for growth in U.S. stocks. Strengthening global economies could also help provide opportunities for U.S. exports, which have been weak in recent years. Employment statistics and corporate earnings remain strong and are key indicators that this expansion has not yet reached its endpoint.
Lagging wage growth coupled with the economic growth mentioned above will keep inflation tempered, which, in turn, should lead the Fed to raise key interest rates slowly and keep commodity prices in their current trading range. A slow rising-rate environment will translate into continued improvement in stock prices and—more importantly— less risk in bond positions.
The dollar would likely strengthen significantly if U.S. rates were rising faster than global rates, but that is not likely to happen in the short-term.
WHY THESE FORECASTS MATTER
These forward-looking forecasts are created from our quarterly Investment Policy Committee meetings, and they are integral to our tactical investment process. Instead of using a buy-and-hold strategy, we understand that risk changes over time, and we make ongoing, tactical changes to our portfolios to consistently move away from risk and toward opportunities. These changes are based in large part on the forecasts enclosed, which are generated from continually monitoring current and historical data and then forecasting future conditions of domestic and global economies and markets.
We hope these minutes help you understand our investment management process, the reasoning behind our actions, and how global indicators affect our tactical changes. We invite the opportunity to discuss our forecasts and strategies in relation to your specific portfolio, financial plan, and personal Investment Policy Statement.
To your fiscal health,
|Earl Knecht, CFP®||Kelly Crane, CFP®, CFA, CLU, MBA||Bob Lance|
|Portfolio Manager||President & Chief Investment Officer||Director of Operations|
1 Source: JP Morgan, Guide to the Markets, 2Q2017
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Stock investing involves risk including loss of principal.
Asset allocation does not ensure a profit or protect against a loss.
An increase in interest rates may cause the price of bond mutual funds to decline.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
Mortgage backed securities are subject to credit, default, prepayment, extension, market and interest rate risk.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained.
Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Municipal bonds are federally tax-free but other state and local taxes may apply. If sold prior to maturity, capital gains tax could apply.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Interest income may be subject to the alternative minimum tax.