By Gary Stringer, Kim Escue and Chad Keller, Stringer Asset Management
Despite recent market volatility, we think that the current business cycle will extend for at least another year, if not longer. Equity markets tend to peak approximately six months before the end of a business cycle. As a result, we expect continued stock market appreciation, albeit at a slower pace and subject to bouts of volatility.
Historically, most bear markets are associated with recessions (the end of a business cycle). Every U.S. recession in at least the last 50 years has been proceeded by an inverted yield curve, where long-term interest rates are lower than short-term interest rates, and a negative real (inflation-adjusted) growth rate of the money supply resulting from the Fed over-tightening monetary policy and choking off liquidity. In the past, the yield curve has inverted one to two years before a recession and equity prices peak approximately six months prior to recession. Though the yield curve has flattened, and liquidity growth has slowed, we think both point to at least 12 months before recessionary risks becomes acute.
Our work suggests that the Fed will continue raising short-term interest rates over the coming quarters. We think the Fed will raise two more times before pausing. It seems to us that the yield curve could flatten and money growth could slow further in the coming months as the Fed raises interest rates. These events should cause the Fed to hesitate raising rates any further.
One of the reasons we think the Fed should tread lightly is the relationship between nominal GDP (NGDP) growth and the 10-year Treasury yield. Over time, they are highly correlated with an average difference of about zero. During the expansionary phase of a business cycle, NGDP growth tends to run about 1.7% higher than the 10-year Treasury. The gap between the two rates is currently wide by historical standards.
With the backdrop of the Fed tightening monetary policy and the positive impacts for fiscal stimulus, such as tax cuts, fading going forward, we think that the market is suggesting that NGDP growth is likely to decelerate rather than long-term interest rates rising significantly. NGDP is made up of real GDP (RGDP) plus inflation. Market-based inflation indicators, such as 10-year Treasury Inflation Protection Securities (TIPS) spreads, are not breaking higher in our opinion. As the chart below indicates, 10-year TIPS spreads have plateaued at a rate below their business cycle peak in 2014.
As a result, we think that more inflationary pressure is unlikely in this environment. Over the long-term, RGDP growth is driven by the grow rate of the labor force and the productivity growth of that labor force. Since the growth rate of the labor force has slowed due to several factors including demographics, a sustained increase in RGDP growth would have to be driven by an increase in productivity growth. We see that scenario as unlikely especially since research and development spending has been lacking relative to history.
At this point, we think the economy can absorb the interest rate increases. The recent rise in 10-year Treasury yields and the strength of leading economic indicators suggests to us that the Fed does have more room to move.
U.S. leading economic indicators are up more than 6% over last year compared to being flat for developed economies as represented by the Organisation for Economic Co-operation and Development (OECD). This suggests that the U.S. economic growth will continue to lead other developed economies.
We think that shifting markets and volatility will create new investment opportunities. As long as fundamentals remain sound, we recommend staying the course and taking advantage of market volatility and new investment opportunities. In fact, two of our favorite fundamental indicators are weekly jobless claims, or layoffs, and jobs openings. Layoffs are near record lows while the number of job openings is at a record high. Combined, we think these measures paint a picture of a very healthy labor market.
As more jobs are created and wages slowly push higher, consumer spending should increase, which creates a virtuous cycle.
With this relatively constructive view, we look towards equity market return expectations. While the U.S. economy will likely continue providing opportunities for corporate revenue and earnings growth that can support higher stock prices, we expect the rate of growth and the rate of stock price appreciation to slow. For example, earnings yield, the earnings per share for the most recent 12-month period divided by the current market price per share, has historically provided a good indication of stock market returns going forward. Though there are times when forward returns significantly deviated from current earnings yield, like the booming markets of the 1990s followed by the bust of the early 2000s, the current earnings yield has over time provided a reasonable approximation of what to expect for U.S. stock price returns for the next several years.
At these levels, the earnings yield suggests that U.S. equities can compound at a 5-7% annualized total return going forward, stock market volatility aside. With our expectations for investment grade fixed income total return around 3%, we think it makes sense to maintain an equity tilt.
INVESTMENT IMPLICATIONS
In aggregate, our indicators suggest little chance of a recession in the next 12 months, so we expect further economic growth. We anticipate Q3 2018 S&P 500 earnings to be 20% higher than last year. Though we expect the pace of economic growth to slow, along with higher corporate revenues and earnings, this growth should lead to higher stock prices over the next year, though it may be a bumpy ride.
We think the positive effects from tax cuts and increased government spending will fade just as interest rate hikes from the Fed begin to bite. Slower economic growth should keep a lid on long-term interest rates. Slower growth and range-bound or falling long-term interest rates should benefit defensive sectors and longer-duration fixed income holdings, such as taxable municipal bonds. In addition, further rate hikes may benefit floating rate funds as well.
As previously mentioned, we recently added a dividend-oriented domestic equity position that we think can add stability to our strategies.
In addition, we moved back into emerging markets equities. Though we are still underweight emerging market exposure compared to the global equity market and have room to add, we thought that it made sense to start building positions in emerging markets at these levels. Developed markets like Japan also look interesting and we are increasingly watching Europe.
THE CASH INDICATOR
As of the end of September, the Cash Indicator (CI) slipped well below its historical average. This suggests that there is plenty of liquidity in the global markets. However, we have seen a significant uptick in volatility as interest rates have risen. We have been writing about our expectations for greater volatility for the better part of a year and 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 buying opportunities. One of the primary benefits of the CI is to help differentiate between normal market volatility and systematic market breakdowns. Our work suggest that this is the former.
This article was written by Gary Stringer, CIO, Kim Escue, Senior Portfolio Manager, and Chad Keller, COO and CCO at Stringer Asset Management, a participant in the ETF Strategist Channel.
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.
Index Definitions:
S&P 500 Index – This Index is a capitalization-weighted index of 500 stocks. The Index is designed to measure performance of a broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.