Fixed Income Market Outlook – 4Q 2017

  1. Fixed Income Market Outlook – 4Q 2017

    Fixed Income Markets From the outside looking in, fixed income markets had a fine year. We enjoyed positive returns, abundant liquidity, and unusually low volatility. While we still expect positive returns in 2018, we see a changing narrative informing our view of what is to come. The fact is that 2017 ended much stronger than it began. After stumbling in the first quarter, GDP is now expected to notch its third consecutive quarter of 3%-plus growth when the fourth quarter is reported, something last seen in 2004-05. Consumer spending is up and manufacturers struggle finding workers to meet a growing demand. Tax reform is expected to provide additional funds for companies to direct towards investment and higher wages. Job growth is still expanding at a pace that will move the unemployment rate down. It would be faster still but for a continuing skills mismatch between hiring companies and the unemployed. And inflation, while still below the 2% target set by the Federal Reserve, will be pressured to higher levels in the coming year. There are also the actions of the Federal Open Market Committee (“FOMC”). They undertook three rate rises in 2017 and are currently forecasting three more for 2018. They also began reducing their balance sheet in October by $10 billion/month and will work their way up to $50 billion/month by the end of 2018. This represents an aggregate $450 billion reduction over 15 months, just a 10% slice from a $4.5 trillion pie. Too slow in our view. Even so, this action alone presents…

  2. Equity Market Outlook – 4Q 2017

    Equity Markets As we entered 2017, we thought conditions were ripe for positive equity returns; something on the order of 8-10%. It turned out substantially better, with all the major U.S. equity indices returning double digits for the first time since 2013, and international indexes doing even better. Our proprietary screening models are revealing more interesting companies from a broad range of sectors. For active managers like us, digging deeper reveals an even better story. As the year progressed and concerns of overvalution grew, we remained bullish. The economy was picking up. Jobs were still being created. Earnings were still strong and growing. And we continued to identify names whose value we felt was not fully reflected in their price. Valuations aren’t cheap, but we still define them as fair. We did witness periodic rotations from sectors that had done well (i.e., semi-conductors and software) to sectors that had lagged (retail and financials). For example, Amazon finished the year up over 50%, beating the S&P by 30%. Yet there were points where Amazon lagged the broader indices by more than 10%. The same thing happened with banks, retailers, semi-conductors and others. The Consumer Discretionary sector was the strongest in Q4, after posting the weakest returns in Q3, and Technology returns were among the strongest, again. Energy and Telecommunications, two sectors struggling with volatile commodity prices and intense competition respectively, were the only sectors to post negative returns for the year, despite turning positive in the second half. The widespread reach of automated trading programs and passive investors contributed to…

  3. Interest Rates – 2018

    Interest Rates – 2018 In 2018, we expect: • Job growth will continue, albeit at a slower pace than before. That growth will exceed new job market entrants, which will continue to put upward pressure on wage growth. • We expect GDP to continue its slow move to a higher sustainable rate into 2018 which will pressure the Fed to consider removing accommodation faster than they would like. • Coupled with inflation readings that will exceed 2%, we see the long end of the yield curve starting to move materially upward along with the short end as the Fed hikes rates 3-4 more times in 2018. To support our outlook, consider the following. In 2017 we saw the Federal Reserve meet its rate changing expectations. Median forecasts for the Federal Funds rate suggested 3-4 rate rises. The Fed has now raised rates three times in 2017. As is usually the case, the 2 year US Treasury Note has been moving upward along with the overnight rate. However, what happens further out on the yield curve could have greater long-term consequences for fixed income investors. Long-term rates are not moving upward in this environment, but are actually moving down, raising concerns over the risk of an inverted yield curve and the downsides that can often follow such occurrences. What is behind this state of affairs? The simplest explanation is to recall that short rates are most sensitive to Fed policy expectations. Short rates can fluctuate wildly based on how markets think the Fed will interpret new…

  4. Market Outlook – 3Q 2017

    In my opinion, it is wise to generally avoid pessimists and political provocateurs. Yes, they are right sometimes (and how they love to tell you when they are), but their stock-in-trade is to tell you how the American economic system is going down the tubes. Rather, I prefer to focus on being objective and optimistic. The American economic system is a very powerful engine. When good companies run by talented leaders grow their revenues and earnings, it can produce an impressive market environment. Equity markets posted another strong quarter. Corporate America reported earnings that met, and in many cases, exceeded our expectations. Their forward guidance on revenue and earnings growth are the center of our optimistic market outlook for the fourth quarter and into 2018. Revenue growth among larger companies still exceeds mid and small firms, but the gap is narrowing. Year over year revenue growth for large companies increased to 7.6% in the second quarter (from 7.4% in Q1). For mid-sized companies year over year revenue growth increased to 7.3% in the second quarter (from 6.0% in Q1). We see four things here. One, increasing revenue is the single best source of support for continued earnings growth. Two, there is a sizable gap between earnings and revenue growth which reveals the continuing positive effect of cost cutting implemented in past years. Three, larger companies have greater operational leverage that usually manifests itself first in a growing economy, but mid-sized firms are now starting to catch up. Four, while companies with foreign exposure have done…

  5. Are value stocks dead?

    How is it that stock markets can continue to hit new highs when the world is facing so much uncertainty? From the toll of natural disasters to an increasing array of political populism and saber-rattling of North Korea, nothing has yet sent markets off course. The fact is that financial factors still matter more. But when we look past the broad averages and push a little deeper, we can see asset class diversion that puts a different story behind the numbers. We have been keeping track all year of the performance gap between growth and value stocks. The former is up more than 19% while the latter has only managed a 5% gain in 2017*. Why has growth done so well while value has not? There are several explanations for the difference and there is something we can do about it. A small part stems from value’s strong performance in 2016 when it was up over 18% vs 7% for growth. Some of this is simply mean reversion. A more meaningful explanation derives from economic growth. Growth typically does better when economic growth is modest, while value typically does better when economic expectations are generally rising. Our economy is still growing at about the same 2% average we have seen since 2008, a bit of a letdown from higher expectations held at year-end. Investors put a premium on companies that can generate above average growth in any environment, which explains why technology is the only sector to exceed the overall returns from growth benchmarks. This…

  6. What will tomorrow bring

    “It was the best of times; it was the worst of times.” We make no claim for originality — that belongs to Charles Dickens, writing in the nineteenth century about an event, the French Revolution, that occurred in the eighteenth century. All that brings to mind an old cliche: “The more things change, the more they remain the same,” or even Dwight Eisenhower’s famous garbled quote: “Things are more like they are now than they ever have been.” The point of this verbal meandering? Simply that the world is always unsettled somewhere. Good and bad events are not mutually exclusive, they have gone on side by side for all of history. As investors, we watch events and consider how they will affect the economy, politics, and, most important, our portfolios. The truth is, we can only guess. We can make educated guesses based on history and experience, but, in the end, there is no certainty. That is why our focus is on earnings and growth. How should this uncertainty influence your investment decisions and instructions to your advisor? That depends, to a great extent, on your personality, your investing horizon, your goals, and the impact it has on your tolerance for risk. When Mitchell Capital is engaged, new clients create a set of investment guidelines, basically setting limits on the equity and fixed income components of their portfolios. These are the directives our managers will follow and serve as the guideposts for moving forward in an uncertain world. At their best, guidelines strip the emotion…

  7. Market Outlook – Q2 2017

    Equity and bond markets posted positive returns for the quarter, which were spread evenly throughout.  Longer interest rates ended slightly down, giving fixed income investors a small boost.  First quarter earnings reports revealed a 14% year-over-year improvement, the best in over five years.  Supporting these gains was the best European growth in seven years, particularly benefiting domestic companies with large international operations.  The range comprising that average is wide with Financials up 20%, and Tech up more than 17%, while Utilities were up 5% and Telecom was down 5%.  This also explains the large gap between the increase in earnings and our own GDP.  We are encouraged to see our two economies finally moving in the same direction again and this supports our expectation for earnings growth of 8-10% through year end. Among larger companies, revenue growth is picking up.  Using the S&P 500, average revenue growth over the last five years through Q1 2017 was 5.6%.  Over the final twelve months of that period it was 7.4%.  Since 2009 companies have better managed their expenses and bought back a great deal of their own equity, both of which contributed to rising earnings per share in the face of relatively flat revenue growth.  Increasing the revenue line provides a more direct and longer-lasting path to earnings growth and we believe this will continue for now.  Trading currently at 17.7x next years projected earnings, stocks remain reasonably priced. This should keep the stage set for continued equity appreciation through year-end, though perhaps at a slower pace…

  8. Aren’t low oil prices good? It depends on why.

    Back before “fracking” became a household word, most people considered cheap oil a good thing. Gas was once under a dollar a gallon; airlines liked cheap aviation fuel; chemical companies liked cheap raw materials. Of course, we were dependent on imported oil, and every OPEC meeting sent a ripple of unease through the markets as the threat of a price increase hovered in the air. Expensive oil was considered bad for the economy. Now that fracking and other improved recovery methods have dramatically increased domestic supply, there are concerns that cheap oil will stall the economy. Does this make sense? It is true that oil producers and economies dependent on oil production are facing serious issues. Venezuela is the poster child for a directed socialist economy reliant on oil and failing as its income declines. Russia, OPEC and domestically, Texas, are all feeling the pinch. Profitability of oil producers and their suppliers is affected as the price declines, but the corollary is that consumers of oil benefit, and there are more consumers than producers. Oil is used for all forms of transportation – road, rail, air and water. Heating oil is a winter necessity for much of the world. Oil is vital for lubricants and the petrochemical industry — fertilizer, synthetic fiber, synthetic rubber, pesticides, perfumes, paints, dyes and on and on. The reason oil’s price has declined is not that the economy is weakening, it is that production has increased, and even as the price has declined, producers are finding cheaper ways to extract…

  9. What happened to tech last week?

    Stocks go up; stocks go down. Tech stocks tend to do those things more extremely than most other stocks. They are volatile because their underlying businesses grow quickly and have become huge. They are subject to consumer preferences and the ebb and flow of innovation and product cycles. That said, they represent the most dynamic and fastest growing sector of the economy, and technology is not going away. They cannot be ignored. The recent correction among tech stocks last week was to be expected. They have led the market all year. There is a rolling correction going on throughout the market, and this is a healthy phenomenon. It is far preferable to a major overall correction which can cause unnecessary panic. We monitor profit/earnings ratios and growth rates carefully. We understand that no stock will go up forever, but also that investors in even the most successful companies must be prepared for some volatility in their stock prices. We also believe that volatility can at least be moderated by investing in suppliers to the tech giants. This flattens the risk with diversification while still participating in the sector. We see no need for alarm in the recent tech stock pullback, but we remain alert to news from the companies they represent and from government and media sources that may affect their future performance. For investors with a lower tolerance for volatility than may occur in the Mitchell Capital growth portfolio, which holds a substantial set of tech-related stocks, we also offer value and international portfolios,…

  10. Unpredictable

     The stock market will go up. The stock market will go down. The sun will rise tomorrow. All of these things are true. The difference is that we can predict the third one. The Farmer’s Almanac will tell you exactly when and you can bet the ranch on it. If somehow you lose, you won’t need the ranch anyway. Everybody wants to be invested when the market is rising, and historically it has always gone up over the long term. This is because populations and economies have been growing for centuries. The problem is that there have been some very significant hiccups along the way. The market is well along on a multi-year rally, and, so far, enthusiasm for promises made by the new administration have kept it rolling. Can we expect it to continue, and for how long? See the first two statements above. Economist Ed Yardeni makes the case that investors keep buying dips because feared crises like a euro meltdown caused by Greece, or a recession caused by the drop in oil prices, or any number of events publicized in panic mode have failed to materialize. “Nothing bad is happening, and that’s good news for stocks,” says Yardeni. Of course, that can change in an instant. A major force behind stock prices is earnings. Earnings season is upon us, and reports are consistently good. Earnings of S&P companies reporting so far are up 14% year over year. On the other hand, first quarter GDP came in at an anemic 0.7% growth rate….