Talk about a rollercoaster ride. Stocks around the globe were slammed to begin the year, with many major indices down double digits almost instantly. Then - in a not so remarkable (at least to us) turn of events - stocks reversed course and finished the 1st quarter flat or even slightly higher.
How can we explain the drastic shift in the span of only one month? Did the global economy - or at least expectations around it - finally start rocking? No. Was it Congress passing major tax / regulatory reform legislation that would change the economic environment forever? Wishful thinking, but again the answer is no. Maybe one of the auto-makers finally introduced a car that was able to run on dirt instead of oil? Not that we are aware...
What happened? Fortunately (or unfortunately, depending on one's perspective), we seemed to have foreseen the answer in our last quarterly update and outlook for the year. While nothing much changed for the global economy in the 1st quarter, what did happen was that expectations for rate increases by the Fed dampened significantly. This was quickly followed by the Fed themselves confirming those expectations in their commentary - once again largely blaming "global uncertainty" for their more dovish tone. (Not to be outdone, the European Central Bank announced that they were targeting negative interest rates, and added that they could be buying corporate debt in addition to the government bonds already being purchased through their QE efforts.)
So, it seems that we will keep kicking the can down Main Street in this town unofficially known as Bizarro World, USA. The formula looks something like this:
Growing Global Economic Uncertainty
+ Slowing Corporate Earnings
+ Ever-Growing Mountain of Government Debt
+ Completely Broken Congress
+ Geopolitical Unrest
+ An Indescribably Comical / Frightening Election Cycle
= Stocks continuing to......rise??
Now, there are certainly those who will remind us that "stocks lead the economy, not the other way around". And one can correctly point out the positive aspects of the economy omitted from the above equation - the most prominent would include a declining unemployment rate, improving real estate valuations, as well as seemingly robust consumer spending in the U.S. The addition of those to the previous equation would certainly make it more palatable to most.
Here is the problem - name one of the positives mentioned not directly correlated to the historically low interest rates of today? One cannot responsibly do so. Worse yet, the rates are the direct result of manipulation by central banks in this country and around the world - not the result of "efficiently functioning markets". The end result of said manipulation is cheap money. This cheap money can cause home values to rise, since the mortgage payments are lower. Consumers assumptively will spend more often and at higher prices - largely borrowing that cheap money to do so. And yes, this should lead to more hiring by businesses as they attempt to meet increased demand for their products and services. None of this is rocket science.
The question we must ask is this - what happens when the cheap money dries up? We need only look at the past 20 years to find two possibilities - the "dotcom" bust from 2000-2002 and the historical collapse in both home and stock prices during the "great recession" of 2008-2009. Both were preceded by the Fed reversing earlier course and raising interest rates - in other words, money was becoming "less cheap" to borrow. It should be noted that the "great recession" is a far better example of the correlation between cheap money and asset prices, but that is a discussion for another day. Asset prices rise too far and too fast with the availability of very low borrowing costs, then - once the money isn't as cheap anymore - prices fall back to reality in painful fashion.
Of course, because today's cheap money is the direct result of manipulation rather than market forces - we must also ask the questions "when", "how" and even "if" it will end? Will the central banks successfully be able to "normalize" rates without economic catastrophe? Will the central banks even be in control - or will the mountain of outstanding government debt ultimately end the manipulation for them? Finally - and this is very important - can we even be certain that cheap money is not here for good? Economic principles would seemingly dictate otherwise - but then again - economics is not an exact science....
For the time being, it seems we were correct in our assumption that the Fed would have very little resolve to follow through on their rate-hike expectations announced back in December. As a result, we would be less than shocked to see both stocks and bonds resume their recent trend higher - although we would expect any gains to be muted for a variety of reasons. At the same time, we continue to perceive the overall risks generally outweigh the potential reward - at least for the short-term - and that portfolios should reflect as much.
For our clients, we hope the above commentary sheds further light on recent discussions on investment strategy. As you know, our general position continues to favor the "reduction - not removal - of risk based on perceived valuations". These "perceived valuations" can more simply be described as our belief that asset prices are over-inflated, resulting mainly from the continued presence of ultra-low interest rates and cheap money. Our belief applies to bonds and other income-producing investments, as well as to stocks and real estate.
Importantly, we have also described why we do not (and likely never will) suggest the complete removal of risk (or growth potential) from one's portfolio. Since it is the result of manipulation by the central banks, we can have no way of knowing when (or even if) the cheap money party will come to an end. As such, there are significant risks to having all of one's money "protected" in cash - earning a negative real return in the current environment - while other asset classes may continue to rise in price.
So we once again reiterate our suggestion of tactically allocating around one's target asset allocation - always based upon one's short and long-term objectives and considering tolerance for risk. In the current environment, we continue to prefer relative safety over risk - or protection over growth potential. As always, this does not mean one should ever abandon potential growth or safety in favor of the other. We must always remember that no one (including the author) can know with certainty what lies ahead for markets, interest rates, or economies. This is particularly true when focusing on the short-term. That said, we should always recognize environments where abnormal risks or opportunities present themselves - and make adjustments to our investment strategies accordingly.
One final note - we do recognize (and are often reminded) that our commentaries of late have been on the redundant side. It derives not out of lack of other topics to discuss, but rather our belief that there is nothing more important to talk about. We are often asked by clients what will have to occur in order for our outlook to change. In all likelihood, the answer to that question is one of two scenarios. One would be a significant decline in asset prices, a substantial rise in interest rates.....or both. The second would require our being strongly convinced that recent monetary policy was "sound" in theory, and that there will be no significant or lasting negative effects on asset prices and the economy. While preferring the latter, we unfortunately believe it more likely that there will be a period of "short-term pain" that will have to precede a more optimistic view of return expectations. Our goal remains to attempt to minimize any short-term pain, then look for opportunities that we would expect to again present themselves.
We ask you to please reach out to us with any questions, concerns or comments about anything you have read here - we truly appreciate all feedback. More importantly, we constantly strive to communicate our thoughts and strategies as clearly as possible to our clients - and your questions and comments are tremendously helpful in allowing us to best achieve that goal. And always feel free to share this with friends or family who might be interested in or benefit from this content - and direct them to our website (roundhillwealth.com) where they can find this and all other commentaries in our blog section.
Always most important - to all of our clients - we can never thank you enough for the trust and confidence you have placed in Round Hill Wealth Management.
|Douglas Brymer||David Swanson|
|President & Wealth Advisor||Principal & Wealth Advisor|
The opinions expressed in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Tactical allocation may involve more frequent buying or selling of assets, and investors should consider the tax consequences of moving positions with greater frequency.
No strategy assures success or protects against loss.
Securities offered through LPL Financial. Member FINRA / SIPC. Investment advice offered through HighPoint Advisor Group, LLC a registered investment advisor. Round Hill Wealth Management and HighPoint Advisor Group LLC are separate entities from LPL Financial.