GOLDILOCKS AND THE THREE BULLS
2017 is shaping up to be a surprisingly good year for investors. One of the biggest surprises is that three typically uncorrelated asset classes – stocks, long-term bonds, and gold – were all up 8-9% in the first half of the year. That’s a big move, and these assets very rarely move in tandem like this. They are supposed to offset one another, diversifying away market risk when one zigs and the others zag. Folks would be a lot more worked up about this if they were all down 8-9%!
We’re glad they’re all up, but they can’t all three be right, can they? Typically, rising inflation expectations are good for stocks and gold, but bad for long-term bonds. Accelerating economic activity is generally good for stocks, bad for bonds and gold. Heightened geopolitical tensions are good for gold and bonds, bad for stocks. And so forth… So, what gives?
First, we believe solid economic fundamentals and lower inflation expectations 5-10 years out have assuaged concerns for investors in long-duration assets (stocks and long-term bonds). Second, we think the rally in gold prices earlier this year reflected a short-term supply-demand imbalance, rather than a reflection of rising geopolitical concern or rising inflation expectations. Geopolitical concern has been prevalent for years (to put it mildly), and inflation expectations are still muted. Besides, we don’t subscribe to the theory that gold is a very effective hedge to these risks over either the very short term (measured in months) or the very long term (measured in decades). Like any currency, the only reason gold has value above its industrial characteristics is simply because people believe it has value. Big swings in demand on limited trading volume render gold too volatile to be a serious contender in the world monetary system, but it can serve as a useful barometer of sentiment.
A third reason could be that the political climate is contributing to unified strength in these three conflicting markets – but perhaps not in the way you might think. First, partisanship and conflict lead to gridlock, and the markets perform well when things don’t change. Second, partisanship and conflict also lead to pessimism, and the markets perform well when the concerns (thus far) prove to be unfounded. We’re not saying that we’re happy about the political divisiveness in our country, but the markets do seem to like it. For now, anyway.
Not Too Hot, Not Too Cold
As we mentioned in our last quarterly newsletter, The Unloved Market, this expansion looks like it could become the longest on record – and by far the weakest. It’s been 97 months since the Great Recession ended in 2009, a duration surpassed only by the recoveries that began in 1961 and 1990.
But we sure haven’t covered very much ground over these past eight years. The growth in GDP during this cycle is a fraction of that seen in typical expansions. The chart below shows the cumulative percentage growth in real (inflation-adjusted) GDP during each business cycle during the post-war era. The current cycle started at the prior peak in July 2007, hit rock bottom nearly 18 months later, and now, eight years on, GDP is only about 12% above where the cycle started. That doesn’t hold a candle to the 40-50% growth during prior cycles of comparable duration.
Just 12% in eight years! It’s like a slow, grueling climb to the first floor of a five-story building. We aren’t seeing anything close to the excesses that typically precede a severe recession. A little one, perhaps, but you don’t fall far from the first floor.
That’s reassuring! It’s also reassuring that we don’t yet see a recession – even a little one – on the horizon for the next year. The consumer has been the key driver to this recovery. Household finances have improved, and household net worth has risen 42% since the peak in 2007. Faster job growth and a growing labor force combined with modest wage inflation suggest that the 8-year-old employment recovery, and the economic expansion along with it, both have some room yet to run.
Apart from the consumer, the rest of the economy (which includes the government, corporate, and foreign trade sectors) seems to be doing pretty okay, too. U.S. leading indicators have risen 6 straight months and the Chicago Purchasing Managers Index jumped to a 3-year high in June, rising above 60 for the first time since 2014. The strength in the U.S. economy is echoed overseas, where inflation and bond yields are falling while economic growth and earnings are accelerating.
Bottom line, the global economy seems to be fine; not too hot and not too cold. But experience has taught us time and again that solid economic growth does not necessarily coincide with solid stock market returns. Global economic conditions are important, but many other things impact investments, too.
As we determine our investment strategy, we weigh the evidence and outlook presented by the macro factors that drive global markets over the long term, filter out the noise of day-to-day distractions, and focus on what really matters for investors.
Thus far in 2017, healthy corporate earnings, improving economic growth, and relaxed political risk in Europe contributed to broad-based investor optimism. Indeed, all but four of the 30 major world stock market indexes are in positive territory this year. According to The Wall Street Journal, the breadth of global performance in the first half has been unmatched since 2009. Global stocks as measured by the MSCI EAFE Index rose more than 4.2% in the second quarter and are now up 14.2% year-to-date. Here in the U.S., the S&P 500 gained 3.1% in the second quarter and 9.3% year-to-date. This was all the more remarkable amid mixed economic data and political uncertainty over the ability of the administration to push through its growth policies. The rally faded in the final week of the quarter as global central bankers hinted that their policies would soon shift from accommodative to restrictive, which implies reduced bond purchases and rising interest rates that could choke off the nascent recovery in Europe and abroad.
These same concerns weighed on the dollar, which dropped 4.9% in the quarter and is down 6.0% year-to-date. Likewise, oil prices dropped to $46.04 per barrel from $53.72 at the start of the year as global gasoline demand appears to be weakening. U.S. bonds also pared their gains in the final week of the quarter, with the 10-year Treasury ending the quarter with a yield of 2.30%. Leading up to this, the bond market held steady during the quarter as economic data was positive and inflation remained subdued. Longer-dated bonds did well, while short-term bond yields rose (prices fell) along with the Fed’s 0.25% interest rate increase in June. Corporate bonds as measured by the BofAML US Corporate Master Index posted a solid 2.4% gain in the quarter and are up 2.3% over the past 12 months. High-yield or junk bonds did even better, up 2.1% for the quarter and 12.8% for the year ending June 30.
The strong start to 2017 bodes well for the second half: According to Strategas, in years when the S&P 500 is up more than 8% in the first six months, the index gains more than 7% on average during the second six months of the year, versus the 4% average gain for all second-halves since 1950.
Circling back to the stock-bond-gold conundrum… While short-term anomalies like this do happen, we do believe in mean-reversion, which means the coming months may prove difficult for one or more of these three asset classes. Given our outlook for benign inflation, still-low interest rates, and sound economic growth, we believe we’re much closer to the end of the cycle than the beginning. But it is shaping up to be a very long cycle. Market returns may be more muted from here, but we believe it’s more likely that stocks will be the winner versus long-term bonds or gold.
Thank you for entrusting us with you investments.
If you have any questions about your portfolio or about the markets in general, please contact us at 206-223-9790. We stand ready to assist you.
 We generally shy away from sharing our political opinions. Our goal is to present a balanced and unbiased perspective on the markets, with a blend of conviction and humility that comes with professional experience.
While the information in our newsletter is obtained from reliable sources, we do not guarantee the accuracy of the information. Past results are not an indication of future performance.