Notes on the week aheadContributor Dr. David Kelly
I should state, at the outset, that I do not profess to have any deep understanding of quantum mechanics.
However, apparently it all has to do with this guy called Schrodinger who keeps his cat in a box. This, on its own, would disqualify him as an ideal pet-owner but to make matters worse, the cat has to share its quarters with a flask of cyanide which has a 50/50 shot of having been broken by a hammer. It would seem reasonable to conclude, then, that there is a 50/50 shot that the cat has perished. However, oddly enough, this is wrong. Schrodinger’s cat exists in alternative realities, both alive and dead at the same time, and it is only when Schrodinger opens the box in the morning to let the cat out, that these realities have to collapse into one.
Similarly, the U.S. bond market and the U.S. stock market seem to coexist in alternative realities today.
The bond market’s reality is an economy on the edge of recession. After Fed communications this week dropped some pretty broad hints of a July rate cut, the fed funds futures market priced in three full cuts before the end of the year. The yield on the 10-year Treasury bond also dipped below 2% for the first time since 2016, in a clear sign that investors expect multiple rate cuts.
In the world of the bond market, the economy is slowing, and fixed income investors will be looking to this week’s report on Durable Goods, as well as advance reports on Inventories and International Trade, to confirm second-quarter economic growth well below 2%. While Thursday’s Unemployment Claims report should continue to portray a very tight labor market, falling levels of immigration and slow growth in the working age population should continue to limit payroll gains, following May’s dismal +75,000 reading.
Bond investors will also look to Friday’s data on the Personal Consumption Deflator for evidence that core inflation is firmly entrenched at levels well below the Fed’s 2% target. In the world of the bond market, core inflation will be held down by weak wages. In addition, oil prices, which have risen slightly on Iranian tensions, should retreat as the U.S. Administration backs away from military action while the dollar will be kept elevated by actions of overseas central banks that are even more dovish than our own.
Finally, in the world of bond investors, no true resolution to the U.S./China trade dispute will emerge at the G-20 meeting in Osaka next weekend. Rather, we will see continued trade uncertainty, even as trade talks resume, with a dragging impact on global growth. This drag, which was very evident in last week’s flash PMI reports, is gradually spreading from global manufacturing to global services.
The reality portrayed by the stock market in the last week is quite different. The S&P500 rose another 63 points last week, hitting an all-time record high on Thursday and is now up 17.7% year-to-date. More impressively, the forward P/E ratio has now risen to 16.8 times, above its 25-year average. This is despite the fact that margins are very elevated, the economy is slowing down, and companies have been cutting their own earnings projections.
However, in the stock market view of the world, this is a new normal, with the economic expansion likely to continue for years to come in an era of high profits and low interest rates. On the issue of growth, equity investors can point to an impressive May retail sales report. Consumer Confidence numbers on Tuesday and Consumer Sentiment numbers on Friday should remain at high levels. If consumer spending continues to grow solidly, the economy should be able to avoid recession. And if there is no recession, earnings should continue to grow, albeit slowly.
In the world of the stock market, the Federal Reserve will cut rates, not because of the risk of recession, but rather in response to political pressures and the reality of low inflation. With even lower interest rates, investors will have little choice but to continue to plough money into U.S. stocks.
In some ways, these alternative realities were reflected in the FOMC forecasts released on Wednesday afternoon where, of 17 members participating, 8 believed that there was no need for a cut in rates this year, while 7 thought there ought to be two rate cuts. (For the record, one member recommended one cut and one recommended one increase).
This divergence of opinion, like the divergence between the perspectives of the bond market and stock market, should be resolved over the next few months. A few more reports on the job market and consumer spending should give a better sense of economic momentum at full employment and as the impact of tax cuts wane. In addition, a few months should probably resolve the question of whether China and the United States are likely to come to a comprehensive trade agreement in advance of the U.S. 2020 elections.
In the meantime, investors should consider the implications of the uncertainty.
- First, it is really too close a call, for now, as to whether the stock market or the bond market has it right. Consequently, investors should not bet too heavily on one outcome or the other but rather remain well diversified.
- Second, it is important to acknowledge that both the U.S. stock market and bond market are richly valued as of right now. Consequently, a plain vanilla U.S. stock/bond portfolio should provide only modest returns going forward, highlighting the value of great managers both in the realm of sector and securities selection and the importance of diversification into international equities and alternative assets.
- Third, for long-term investors, it is important to emphasize that the global economy, unlike Schrodinger’s cat, runs no risk of being dead for good. Even in a worst case scenario, the economy and markets will revive. The most successful investors will likely be those who focus on valuation rather than timing and are thus positioned to benefit when the economy, once again, begins to purr.