Update on the Markets

July 1, 2019

Don’t Fight the Fed

The second quarter of 2019 witnessed stocks hitting new highs and the 10-year US Treasury yield dipping below 2.00%. Despite persistent threats about a growing trade war with China, continued delays in finalizing Brexit and Trump even threatening tariffs on Mexico, stocks powered forward. Why? Give credit to the Federal Reserve. For the past several years, central banks were convinced of robust growth and started to raise rates. The Fed started gradually raising rates in December 2015 with the last hike to 2.5% occurring in December 2018. With signs that the global economy was slowing, continued uncertainty regarding trade negotiations with China and inflation below expectations, the Fed reversed course. On March 20 the Fed voted unanimously to hold rates steady and stressed that they would be “patient and flexible” before adjusting rates again. On June 19 the Fed again maintained current rates and Federal Reserve Chairman Jerome Power announced that inflation is not strong enough to warrant further increases. Not only that but if the economy weakens, the Fed may lower rates. Stocks immediately started their upward trajectory, and bond yields plummeted.

Be Careful What You Wish For

Lower interest rates can be quite supportive of stocks. Each dollar of earnings is worth more in a low rate environment. But bond yields and stock prices can’t continue going in opposite directions for long. One of them is right and the other wrong. Right now, the bond market is signaling weaker global economic activity. Is it just a slowdown or a recession? A full-blown recession would hit corporate earnings, and stocks would fall. However, a slowing (but still growing) economy would temper enthusiasm for stocks, letting them rise slowly. Such an environment would also diminish fears of rising defaults and help support high yield bonds. 

It’s Coupon-Clipping Time

With 10-year US Treasury yields back near 2.00% and many foreign bond yields in negative territory, investors are again hunting for yield. Look at these year-to-date returns for income-oriented investments: municipal bonds over 5%; taxable bonds over 6%; high yield bonds over 10%; master limited partnerships over 17%; REITs over 20%; dividend-growth stocks over 20%. It’s safe to say that these numbers are not going to double again by year-end. However, it’s probably not a good idea to book your profits and run. What to do? Everything is expensive, so you can hardly take your money and find great value elsewhere. And increasing risk in a chase for return is not wise either. It’s time to sit tight and collect your interest and dividends: coupon-clipping! We’re likely going to stay in a low-rate environment often dubbed “lower for longer.” Inflation can’t seem to get any lift. Since assets are closer to being fully priced, income will be an important component of total return. I don’t see things changing. 

As for stocks, while I think there’s still room for capital appreciation, most of the gains may be behind us. Dividends will become a bigger share of total return. I’m adding more dividend-oriented equity investments to client portfolios as well as more high yield bonds. High yield bonds are a nice stock/bond “hybrid” in this environment.

It’s not time to reduce equity exposure. Though after such a strong start to the year, a slight cutback may be advisable for cautious investors with shorter time horizons. The economy is slowing, but it’s not dead. We’re still in a wonderful “Goldilocks” environment – a solid economy with healthy corporate earnings and strong labor markets but low inflation, low-interest rates, and an accommodative Fed – all in all a very good environment for US stocks. After the spectacular returns we’ve witnessed so far in this long bull market, there’s still room for more price appreciation, but it’s pragmatic to expect lower returns going forward. Dividends will be a bigger part of your return.

Please let me know if you have any questions or concerns.  

Sincerely,

Henry