While the market seems to be on a rocket ride this year, we may want to move back a little bit and take a look at the market over the past two years. Frequently we look at and are told about the market’s Year-to-Date return. In 2019, it looks fantastic. Who can complain about a 20% plus return in the first seven months of the year? The reality is that 2019 is making up for a lot of the 20% decline in the market over the last four months of last year. When looking from that perspective, we are doing fine, not exceptional, but fine.
This perspective takes all those short-term thinkers that the market has gone up so fast that it is overvalued and thrown them out the window. Year-to-Date numbers can be very misleading. A rolling three-year return gives us a much better perspective.
Our three-year numbers again, suggest that the economy continues to grow, there is little to no inflation, and earnings are on the rise. We have yet to read any research that these characteristics in an economy will bring about a recession. The talk of a coming recession is also quite overblown. Recessions do not show up “because it’s time.” They are not babies! Recessions are caused by a constriction of capital somewhere in the system. Student loan debt, auto debt, and credit card debt are frequently talked about as a constriction on capital. Indeed, we agree. The reason that we are not yet worried about these issues is because the amount of debt here is so small relative to our economy, that they do not have a material impact on business growth and consumer spending.
Top of mind for the market is the interest rate scenarios. What will Chairman Powell and friends do in this convoluted interest rate environment? We really do not have a case that we can look back on history to get an idea of what to do. When have we seen global developed market’s fixed income with negative interest rates? Sure, sometimes a rate here and there has gone negative, but currently over 25% of the global Fixed-Income market is negative. Huh? That certainly gives the Federal Reserve room to move, but at a potential cost of the dollar.
This continues to make our case for us that we are not in an inflationary economy, but in a deflationary one. Global central banks must continue to make money cheap enough to keep economies moving in the right direction. Business’ ability to create more with less has accelerated to such a point that creating supply has not been in the issue in quite some time. Supply is abundant, demand is scarce.
We hear frequently from policy makers that they are trying to create demand. We have continually questioned the ability of policy makers to create demand. Just think about what the government can do that will make you buy something that you do not want to buy. Do board rooms around the country contemplate the actions of the Federal Reserve before they create a new product or service? Our expectation is no; yet they continue to try.
US equity markets are getting expensive from a historical perspective. Does that mean they will not continue to rise? In our opinion no. Investment decisions are based on alternative scenarios and the cost of capital. If you do not invest in stocks, where will you invest? With a historical equity risk premium at 4%, your expected rate of return on equities will be in the 6% range given the current risk-free rate of approximately 2%. Would you be willing to trade that 6% rate of return for a 2% rate? The market is currently telling us no. This is predominately driven by the expectation that the risk-free rate will continue to fall, as is our expectation. There is no inflation, and the Federal Reserve wants one. They will continue to drive their policy to their inflation target of 2%. In our opinion, they will be not be able to get there with the amount of supply that keeps coming on line, quarter after quarter.
Prices cannot rise, and stick, without the commensurate slowdown in supply. We need some serious price wars in several industries for this to happen. We have not seen any yet. Most industries have learned the hard lesson of the past that price wars do not help anyone, but the consumer. They are not interested in engaging in price war to gain market share. They will fight on the cost front, but not on the price front.
We have some tension on the edges in the technology space with employees negotiating harder and harder for increased wages. This industry space, because of its high margins, can withstand this cost increase, as their market space continues to grow with new adapters of their technology and new customers. As these markets mature, technology will begin to go through the price wars of old that should begin to eat into margins and weaken their overall position in their market space. We are, however, a long way off from that happening. Until then, equities continue to have a higher expected value than the fixed income market. This will eventually end, just not quite yet.
As always, please do not hesitate to contact us if you have any questions.
July 16, 2019