Q3 Highlights: A judge who likes beer, rising interest rate fear, and an intensifying trade war.
The US 10-year bond rate is a good proxy for the cost of money. If you need credit to buy a house, car, invest in a business, etc., the rate matters. For example, when mortgage rates go up housing is less affordable and other economic activity slows (i.e. building, materials, plumbing, etc.). If you pay more for debt, you’ll have less to spend and invest. Given that consumer buying is almost 70% of the US economy, high credit cost can hurt economic growth, corporate profits, and lower stock and bond returns.
The 10-year bond broke out of its 5-year range of 1.5%-3.0%, peaking at 3.23%, and causing a small panic in the markets. Is it another head fake or are rates going higher? Jaimie Dimon, CEO of JPMorgan thinks the 10-year rate could go as high at 5%; PIMCO, one of the more reputable bond managers in the world, believes low rates will be with us for quite a while. Markets are trying to figure it out, with tax and trade policy complicating matters.
The flip-side of our unfunded tax cuts is rising national debt. At $21.5 trillion, it’s now larger than the economy. To fund the deficit, the government will need to sell more bonds which may further increase rates and the cost of money. On the trade front, what looked like Twitter bluff and bluster is morphing into ‘my way or the highway.’ China’s trade abuses are well known. Yet imposing 25% tariffs will increase the price we pay for imported goods, offset the tax cuts, and hurt many corporations’ earnings. Political rhetoric ignores the historic economic fact: everyone loses in a trade war. Worthy points to ponder beyond short-term thinking and ballot box politics.
Asset Class Review
US stock markets kept grinding higher. Tax stimulus and dollar strength (due to higher rates) has bolstered US stocks over the past 6 months (from 3/30-9/30). Though after 9/30 they have declined 5% as of this writing.
The Rear-View Mirror is a Poor Predictor
What are the odds that the 10-year US stock outperformance will continue? No one has a crystal ball. However, history tells us naïve extrapolation of trends doesn’t work very well. Since 1900, only one country that outperformed over a 10-year period was able to repeat in the subsequent 10-years. Japan (1970-1989) rode a tailwind of favorable post WWII policies and rapid urbanization; from 1990-2009, the trend reversed, and they lagged other developed economies for 20 years. The table below illustrates outperformance followed by underperformance is a common pattern in capital markets, and why diversification across geographic markets is part of sound long-term strategy.
Valuation, Economic Fundamentals, and Future Performance
To further examine future return potential of US, international developed and emerging markets we assess capital market forecasts from several financial institutions, current valuations, and economic fundamentals.
The table below summarizes forecast and valuation data across asset classes. The PE ratio (the price of a stock divided by profits) is a blunt, yet useful valuation gauge. The CAPE ratio also has its flaws, but it helps to smooth out cyclicality by averaging the prior 10 years of profits. Dividend yield is yet another way to assess value. On all three metrics international stocks are priced at large discounts to US stocks, and growth projections are reasonable given the valuation differences and the past performance of each asset class.
Of note: return projections for every asset class (except commodities) are lower than historical returns. This likely is due to interest rate levels and the aging demographics of the world’s developed economies.
No Risk, No Reward
For emerging markets (EM), Janus Henderson research notes that Harvard, Yale, and Stanford endowments all maintain an overweight exposure to EM relative to the US stock market. In part due to lower valuation; in part due to higher long-term growth expectations.
The headline risk of Venezuela, Argentina, and Turkey gives rise to contagion fears across all emerging markets. In the past, emerging markets have caused investors grief because they borrowed heavily from foreign lenders and ran out of money to pay their debts. Research Affiliates notes that as these markets have accumulated wealth, today these funding risks are small. China, Korea, Taiwan, India, and Russia are 60% of the MSCI EM index; they all carry low external debt ratios, current account surpluses, and large foreign currency reserves.
If US rates rise more, it’s possible EM will feel more pain if money continued to flow out of these economies seeking higher investment yield with less risk. The EM risks are present. They also present higher return potential.
The GSCI Commodities index continued its strong momentum due to its 78% weight in energy; 56% is weighed in oil. Oil price was up about 12% from March, driven mostly by geopolitical factors. Economically sensitive Copper remains down over 16% for the year despite tight inventories.
REIT prices held steady; Bonds continued to struggle against the fear of rising rates.
Low rates have helped to justify higher stock prices. If rates go higher, it’s probable that all asset prices will adjust. The magnitude and decline aren’t known.
Stay tuned on trade and tax policies. For better and for worse, politics can impact economics and investment. And unintended consequences can often result.
“Triumph of the Optimists, 101 Year of Global Investment Returns,” Dimson, Marsh, and Staunton
DISCLOSURE: Investors cannot invest directly in an index. These unmanaged indexes do not reflect management fees and transaction costs that are associated with some investments. Past performance does not guarantee future performance. All investments are subject to risk, including possible loss of the money you invest. Diversification does not guarantee profit or protect against a loss. Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. Please see the Disclosure link at the bottom of the page: www.compoundvalue.com/disclosure/