May 2018 Market Summary

Economic Cross-Currents

I have written during these past few months about how many markets have been in holding patterns.  For the most part, these consolidation phases are continuing with no clear resolution in either direction.  The exception noted in last month’s commentary was the sharp rally in the U.S. dollar, seemingly reversing last year’s downtrend.  This month, while the dollar strength continued, the other asset class breaking out to the upside has been U.S. small-cap stocks as the Russell 2000 index has rallied to new highs.  While the small-cap strength has to be considered a positive for equities, we continue to wait for large-cap U.S. stocks (S&P 500), bonds, and international stocks which all have seemed to continue their sideways movements. 

Perhaps these inconclusive behaviors in many markets reflect the economic policy tug-of-wars going on here and elsewhere.  Here are some counterbalancing factors that we are keeping an eye on:

Economic Headwinds

1. Strong U.S. Dollar.  The surge in the dollar makes our goods and services more expensive (less competitive) vis-à-vis international goods and services.  This provides a headwind to our growth.  We will watch to see if the dollar maintains its strength.

2. Rising Interest Rates.  The Federal Reserve has been steadily increasing short-term interest rates with plans to continue the gradual hikes for the foreseeable future.  Furthermore, the yield curve (the difference between short-term yields and long-term yields) has been flattening (as long-term yields have risen more slowly).  Flattening yield curves are often harbingers of slowing economies with inverted curves (long rates lower than short rates) typically signaling imminent recession. 

3. Quantitative Tightening.  The Great Financial Crisis (GFC) brought forth novel, unorthodox government intervention, primarily the central banks worldwide purchasing trillions of dollars worth of fixed income securities in hopes of driving rates down and stimulating economic recovery.  This became known as quantitative easing (QE).  Now holding trillions of dollars worth of securities on their balance sheet, the Fed is reversing the process and letting the bonds roll off without reinvesting, putting up to $50 billion per month out to the market to finance.  The question is will this extra “supply” trigger higher interest rates and reverse the benefits of QE.  (Truthfully, however, there is dispute as to how much QE actually helped the economy or if the recovery was more organic once the panic lessened.)

4. Rising gas prices.  I’ve recently been reconnecting via back-and-forth emails with an “old” Stanford friend who has spent his career in markets.  He sees the price of energy as the number one market indicator, even pointing out that the GFC occurred at the same time the price of oil was a stunning $150-plus barrel seemingly on its way to $200.  I’m not sure that oil price moves are as impactful as in the past with more efficient energy utilization and growing alternative energy sources but do believe that to some degree higher energy prices can be an impediment to economic growth.  (Another caveat, as we have become such a big energy producer with the shale boom, the energy component of our economy no doubt benefits with these higher prices).

5. Possible erection of trade barriers.  Talk of tariffs and trade wars have certainly been in the news lately, though to date much of it seems to be posturing.  Nonetheless, while there may be viable reasons for these issues being addressed, it seems clear that anything that artificially hinders trade is a negative for economic growth.  Furthermore, the uncertainty even before anything actually is implemented can be an impediment. 

Personally, I find this list to be concerning for our economic growth, especially as this expansion is growing quite old in its 10^th year.  Yet, I also realize that some of these challenges could reverse at any time – particularly dollar strength and higher energy prices. 

Economic Tailwinds

1. Momentum.  The economy seems to be getting stronger and pro-cyclical factors may enforce further strengthening.  In particular, high employment means that more money is going into more workers pockets providing fuel for more consumption.  This is also reflected in very high consumer confidence levels and can create a virtuous feedback loop.

2. Tax reform.  Lower taxes, particularly on businesses, generally are pro-growth as well.  With more money available to spend and repatriation costs falling, businesses have been investing more in expansion particularly in the U.S.

3. Regulatory relief.  I do believe that it is a balancing act in terms of how much regulation is appropriate for our economy to protect consumers while also not getting in the way of economic growth.  The Trump administration has made a big push toward lowering regulations.  While it’s not clear how much red tape has actually been cut, perhaps more importantly there is a perception that businesses don’t have to brace themselves for some unknown costly future regulations.

The truth is that the economy has continued to grow, albeit at a historically low pace as it has for this entire post-GFC recovery.  We will keep our eyes on these countervailing forces and whether or not the markets decisively break out in one direction or other.  In the meantime, we need to keep our seat belts fastened as volatility is likely to continue as long as the economic tug-of-war continues.