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Caution: Speed Bumps Still Ahead

Posted by RAA on Oct 7, 2015 10:34:00 AM


market_updateI
f you have been a regular reader of the investment section of the monthly Compass newsletter, then you know that we have been talking about a market correction for some time. While no one likes to go through a correction, it periodically happens. During a correction, some of the speculation is squeezed out and the market returns to more normal valuations. At the time of this writing in late September, the S&P 500 is down about 11.5% from its all-time high on May 21, 2015, so it is safe to say that the long-awaited correction is upon us. This is a major reason why we have been cautious about this market and will continue to be until it levels out.

Our current position is neutral on the U.S. equity market, underweight the emerging markets (EM), normal weight the foreign developed markets, overweight high quality corporate bonds and short-term bonds, and underweight high-yield bonds and cash.

We find it very interesting that we are seeing an asymmetric reward/risk tradeoff for government bonds. Currently, the Fed really wants to start the renormalization process of raising interest rates, however, the market is keeping the 10 year Treasury just above the 2% level and in a range of 1.6% to 2.5% for almost 2 years.

It is interesting how the market seems to know more than the Federal Reserve Bank with all of its resources. We are still not convinced that the Fed will get to start the renormalization process of raising rates this year. Even the Eurodollar futures (a predictor of future interest rates here) are currently sitting at all-time lows. What this is telling us is that the global economy is weaker than a lot of people want to admit, and if this is true, equity markets will be “range bound” for the time being.

What we also find interesting is that a number of indicators are pointing to low or maybe even lower future interest rates. For instance:

  • The 10-year CPI swap rate is close to its low in late 2008.
  • The 5-year/5-year forward inflation indexed Treasury TIPS is under 2% and very close to where it was right after the Lehman default. This indicator is a gauge of future inflation.
  • Core CPE inflation (what the Fed looks at) is hitting successive cyclical lows.
  • Corporate pricing power is weak, as the world has “too many goods chasing too few consumers.”


All of these things tell us that we might be in a low growth environment for the foreseeable future. This is not necessarily bad for equity markets but it is telling us to possibly lower our equity expectations for the time being.

We recently reviewed a report where the International Monetary Fund is in the process of lowering its estimates again for global growth for 2016-2017. Again, just another indication that for now, we are living in a low growth and low inflation environment. This is bad for savers (no interest on CDs, money market funds, etc.) but good for borrowers. 

China - What’s Next?

Just a few words on China as it is a global growth engine for the EM economy and more. It is hard to figure out how fast China’s economy is growing because their government tells you what they want you to know. However, a few statistics are starting to emerge which may give some hope to China’s economic direction.

The good news is that not all Chinese economic variables are falling. Those indicators that are sensitive to the export/manufacturing engines of Chinese growth, while still weak, seem to be turning around. Bank lending is accelerating, as is social financing. Home prices are also starting to stabilize. While these can turn down again, the good news is that the authorities have gone from ignoring the business cycle to reacting when the data is overly weak or financial markets turn turbulent.

The Bank Credit Analyst is on record saying that China needs to stimulate faster and further to halt the potential for any kind of a deflationary event. Hopefully, that message is getting through to the proper authorities.

 

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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.  

Topics: Investment Updates