“Hot town, summer in the city
Back of my neck getting dirty and gritty
Been down, isn't it a pity
Doesn't seem to be a shadow in the city
All around, people looking half dead
Walking on the sidewalk, hotter than a match head
But at night it's a different world
Go out and find a girl
Come-on come-on and dance all night
Despite the heat it'll be alright
And babe, don't you know it's a pity
That the days can't be like the nights
In the summer, in the city
In the summer, in the city…”
(“Summer in the City”, by The Lovin Spoonful)
“Wait…What?”:“An exclamation when someone suddenly realizes something isn’t right.”
It is interesting how quickly market narratives can change. Just a month ago the “consensus” was the economy was expanding, market complacency reigned, and the stock market would just keep going up.
We, of course, have been concerned for several months with overly low volatility, frothy market valuations, an extremely “narrow” market rally (led by the “FANG” stocks – Facebook, Amazon, Netflix, and Google (Alphabet)), and a flattening yield curve that suggested that both the economy and inflation were slowing down.
It appears that market consensus may be slowly catching up to us. Forecasts are suggesting a much lower Q3 GDP (the Wall Street Journal consensus estimate shows US GDP dropping from 3.0% in Q2 to 2.5% in Q3). Further, driven by sharp declines in housing and construction spending, the New York Fed’s “GDP Nowcast” suggests Q2 growth of only 1.9%, falling to 1.5% in Q3. Inflation fell slightly in May (as measured by CPI and reported by the Bureau of Labor Statistics), and is now up 1.9% over the past 12 months – positive but barely within the Federal Reserve’s target range of 2.0%.
The US yield curve continues to flatten, and perhaps even threatens to invert (when short term rates are higher than long term rates – rarely a good omen for the economy), with only a roughly 0.75% differential between 10-year rates and 2-year rates. The Fed, as expected, raised rates again in June, and continues to forecast at least one additional rate hike in 2017. But the markets (as measured by Fed Funds Futures trading) show distinctly lower expectations than just 4-6 weeks ago. The narrative has shifted from the Fed trying to get ahead of inflationary pressures to building in some capability for policy response if / when the current economic expansion ends.
At the same time, not all is “doom and gloom.” The manufacturing and service sectors remain solidly in expansionary modes, the economy is growing, both in the US and globally. Wages in the US continue to grow more slowly than falling unemployment levels would normally dictate, as automation, globalization, and reduced worker productivity put dampeners on wage inflation. This, combined with the continued decline in oil prices, are the primary factors to decelerating inflation.
Europe and Japan continue to show modest economic improvement, though a stubbornly falling dollar is not helping exports from those regions.
The equity markets continue to grind higher though, as we mentioned above, it is an extremely narrow market rally. By some estimates, the four FANG stocks plus Microsoft have contributed roughly 35% of the total market return so far in 2017. Put differently, without these five stocks, the performance of the S&P 500 this year would be roughly 3.5% lower. If we added in Apple, the distortion becomes even greater.
Last month we anticipated the beginning of a typically slow summer trading season. The US Senate left for its July 4th recess without passing health care reform, dropping the odds of any meaningful reform working its way through Congress before the fall at the earliest (unless, as rumor suggests, Congress decides to skip its August recess and continue working on getting health care and tax reform passed. We’ll believe that when we see it).
We still believe we will enjoy a relatively slow summer, but with a large caveat. The market seems to us to be increasingly precarious – earnings growth is expected to stabilize or slow, the economy seems to be slowing, what market rally we’ve enjoyed has been driven by a disconcertingly small number of stocks, and valuations remain highly elevated.
Should there be some event that shakes the confidence – or even just the current complacency – of the market, we could witness a sharp and rapid sell off. We put the odds of that happening at roughly 25% - 30%, odds that increase come the fall when normal trading activity resumes.
In other words, we are enjoying summer in the city as much as anyone, but the back of our neck feels increasingly dirty and gritty as this market remains hotter than a match head.
With that as a backdrop, looking out over the current economic and investment landscapes, here is what we see.
The Current Economic & Market Landscape
- The global economy remains positive but may be slowing:
- As mentioned, the Wall Street Journal consensus for US Q2 GDP growth remains 3.0%, falling slightly in Q3 to 2.5%. Both manufacturing and non-manufacturing indicators remain at expansionary levels, but have flattened or fallen in recent months.
- Driven by falling oil prices, flat-lined inflation, and slower economic growth, the US yield curve continues to flatten, and is now as flat as it has been since just before the November 2016 elections, with less than 1% separating 10-year and 2-year rates.
- While the US is technically at “full employment” levels, small companies continue to report that they cannot find enough qualified workers to fill a growing number of job openings.
- The Q2 earnings season in the US will not begin for a few more weeks, but early estimates show expectations for another quarter of solid revenue and earnings growth, albeit at stabilizing or slightly reduced levels from the previous 2-3 quarters.
- European Q1 2017 GDP growth was 0.6%, slightly better than expectations and suggestive of continued improvement, especially in manufacturing. It was the strongest quarter’s growth rate since Q1 of 2015, driven primarily by increases in fixed investment and household consumption.
- Prime Minister Theresa May’s “snap election” setback threw further uncertainty into ongoing “Brexit” negotiations, amid signs that the UK economy may be slowing down.
- Japan’s GDP in Q1 was a positive 0.3% -- positive but lower than previous quarters. The US dollar has weakened against both the yen and the euro, which puts headwinds into exports from both of those regions (while helping US exports).
- China’s GDP growth rate in Q1 was 1.3, the weakest report since Q1 of 2016. Estimates for 2017 growth are roughly 6.5%, which would be the lowest (officially reported) growth rate in more than 25 years.
- With the exception of Global Materials, the general commodity complex continues to get pounded by falling oil prices.
The Dynasty Economic & Market Outlook:
The global economy is growing but slowing. Global inflation remains in check and, perhaps, is beginning to show signs of). We remain cautiously optimistic about a continued expansion of global economic activity, though at a stabilizing or slowing pace.
On the investment side we maintain our general market forecast, though in the face of what seems to be an unrelenting slide in oil prices, we have cut our expectations for the commodity and real asset components of our model portfolios:
- Trump’s legislative agenda continues to take a back seat to ongoing scandal mongering and “policy by tweet”. We stick to our call that any passing of major legislation is not likely to happen until late in 2017, and more likely in 2018
- The UK and Japanese central banks will remain accommodative, but the ECB may begin to dial back on its easy policy regime later this year. To date, increased central bank policy divergences have not translated into increased market volatility, which we anticipated but so far have been wrong.
- US public equities still look expensive to us, and market complacency and the narrowness of the market rally concern us. Valuations in EAFE and EM stocks remain more attractive (despite very strong performances thus far in 2017). The USD trend is the wild card for US investors – a continued weakening would put a tailwind behind non-US performance for US-based investors
- The public credit markets still look very expensive to us. We do not expect the US yield curve to continue to flatten too much further, unless future economic or inflation data come in worse than expected. Investors should pay close attention for any signs that the curve might invert, as historically that has not boded well for continued economic expansion
- We think there are better opportunities in the private equity and private credit spaces for investors who can access them, though anticipated spreads to comparable public markets have fallen as investors have piled in seeking premiums
- It is shaping up to be a better year for alternative investments, and we remain more optimistic about hedge funds than liquid alternatives because of lower liquidity and leverage constraints. This optimism has been justified so far in 2017 as hedge funds at the individual fund level generally are outperforming their mutual fund brethren
- Real assets and commodities have been a disappointment this year, as falling oil prices have dragged down the whole complex. We are now less optimistic about the space than we were earlier in the year
Metaphorically speaking, although we assign a fairly low probability to a rapid or dramatic market correction taking place over the summer, our “early warning signals” have changed from a constant glowing green to slowly blinking yellow, as we witness an increasing disconnect between market levels, consumer sentiment, and economic activity.
Enjoy your summers, but we recommend that you keep paying attention, so as to minimize the potential for a “Wait…what?!” moment.
Scott Welch, CIMA®
Chief Investment Officer
Dynasty Financial Partners
Past performance shown is model performance shown is no guarantee of future results. You cannot invest directly in an index.
Source: Bloomberg, Data Analysis, 1/2016-Present
Source: Zephyr, Data Analysis, 1/2016 – Present
Source: Morningstar, Data Analysis, 1/2016 – Present
This presentation is for illustrative purposes only. Past performance is not indicative of future results. The information contained in this presentation has been gathered from sources we believe to be reliable, but we do not guarantee the accuracy or completeness of such information, and we assume no liability for damages resulting from or arising out of the use of such information.
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