By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
U.S. economic growth will likely moderate as the Fed raises short-term interest rates to curtail inflationary pressure. Manufacturing accounts for more than one-third of our economy and the most recent ISM Manufacturing PMI Index reached its highest level in 14 years (exhibit 1). Based on the latest survey data, we think that the U.S. economy is growing at roughly twice the pace of the Fed’s estimate for our economic growth potential.
To understand where we might go from here, it is important to understand the Fed’s general intentions during the business cycle. Early in a business cycle, the Fed encourages above potential growth in order to repair the damage caused by the previous recession.
Later in a business cycle, the Fed tends to lean against economic growth by tightening monetary policy, including raising short-term interest rates, to keep inflation in check. While it is difficult to accurately gauge where we are currently in the business cycle, we certainly are in a long cycle compared to the average since 1945. We are probably somewhere in the late expansion part of the cycle and nearing the peak, but we will not know when we hit the peak until we enter a contractionary phase.
We think that economic growth that has been persistently well above the Fed’s estimated potential growth rate is the primary reason that the Fed expects to continue to raise short-term interest rates well into 2019.
DON’T FIGHT THE FED
With the Fed continuing to temper economic growth with ever tighter policy, we expect the pace of NGDP growth to slow, but not tip into a recession in the next 12 months. This has important implications for investors. For example, there has been a strong relationship historically between NGDP and long-term interest rates, such as the 10-year Treasury yield. Since 1980, the correlation between NGDP and the 10-year Treasury yield has been 0.70 with an average difference between the NGDP percentage growth rate and the Treasury yield of about zero. As you can see in the following graph, NGDP is currently running well ahead of the Treasury yield (exhibit 2). We expect that gap to close, and given the current Fed policy, the gap will likely close as a result of the NGDP growth rate declining rather than long-term interest rates rising.
As a result, we favor investments that can do well in an environment of stable to falling long-term interest rates. These investments include long-term taxable municipal bonds, low volatility equities and defensive equity sectors, such as health care and REITS. Each of these investments can do well as economic growth cools.
THE CASH INDICATOR
The Cash Indicator (CI) has slipped well below its historical average. This suggests that there is plenty of liquidity in the global markets and volatility is tame. Still, we expect the CI to rise, along with equity market volatility, as economic growth slows. Without signs of recession or a huge spike in the CI, market dips should be a buying opportunity.
DISCLOSURES
Any forecasts, figures, opinions or investment techniques and strategies explained are Stringer Asset Management, LLC’s as of the date of publication. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect to error or omission is accepted. They are subject to change without reference or notification. The views contained herein are not be taken as an advice or a recommendation to buy or sell any investment and the material should not be relied upon as containing sufficient information to support an investment decision. It should be noted that the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested.
Past performance and yield may not be a reliable guide to future performance. Current performance may be higher or lower than the performance quoted.
The securities identified and described may not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.
Data is provided by various sources and prepared by Stringer Asset Management, LLC and has not been verified or audited by an independent accountant.