Can superior economic growth overcome rising debt in emerging markets?

Emerging markets[1] have stumbled thus far in 2018 after enjoying solid appreciation in 2017.

Stated economic growth in places like China and India remains well above that of developed economies.  Financial markets appreciated that fact and propelled emerging markets to a gain of over 45% in 2017.[2]

However, 2018 has been a rockier story for emerging markets.  Nearly six months after the solid rally in 2017, emerging markets have declined roughly -4%.

Several reasons include fears of capital outflows following the US Federal Reserve’s intentions to keep raising interest rates in 2018.  Threats of further tariffs by the US on China also have caused concerns over deterioration in emerging market growth rates.  Political unrest in Brazil has also weighed on sentiment.

However, the biggest potential overhang to emerging markets might be debt.

Emerging Market Debt Rising with Growth – What Gives?

The chart above compares total government debt in emerging markets vs. developed economies.

Moody’s, a global debt rating agency, tracks the level of national debt (akin to Treasury bonds in the US) relative to Gross Domestic Product (the level of economic output for a given country).  Averages are then computed for both emerging markets (the light blue bars) vs. developed (the dark bars).

A couple of trends bear watching:

1. Emerging markets have lower debt to GDP than developed markets. This trend has been in place since 2007, the eve of the Global Financial Crisis.  There is a big “but”.
2. But emerging market levels have closed the gap with developed markets. While developed markets witnessed a decline in debt since the peak in 2013, emerging markets have actually grown consistently since 2007.  The gap has narrowed from roughly 30% in 2013 to only 10% in 2018.  This is notable given the gap in interest costs emerging markets pay relative to developed markets.

A growing debt to GDP ratio implies that economic growth is dependent upon debt issuance.

Debt issuance, particularly in emerging markets, can be a fickle source of funding growth.  Flows of capital into emerging market debt has been historically volatile.  Interest rates can rise sharply if foreign outflows were to occur.  Because the size of emerging market debt markets is much smaller and less liquid than in developed markets, interest rates can spike more sharply if investors were to pull out capital.  Spikes in interest rates can depress future economic growth.

Developed countries in Europe and the US were most affected by the 2008 Financial Crisis.

In efforts to prop up their economies and save their banking systems, central banks and governments collaborated to inject money into their economies.  Consequently, many developed countries suffered from rising debt to GDP levels.  As economic growth has returned, debt to GDP has started to decline.

In contrast, debt to GDP in emerging markets has risen despite economic growth.

One factor is China, where fiscal deficits and other stimulus attempted to prop up high growth rates.  The question exists as to when and how much will growth in China slow.  China cannot continue its rate of debt expansion.  Other economies in Asia and Latin America also experienced growth in fiscal spending and domestic credit expansions.  The idea was this stimulus would offset declining growth in world trade.  Unfortunately, emerging markets might now have entered a phase where they have less ammunition to confront a global environment of rising interest rates and positive, but not spectacular, global growth.

Growth and interest rates are the key factors to watch for emerging markets.

Let us help your family to navigate through this challenging environment.

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[1] For a definition, see Kimberly Amadeo, “What Are Emerging Markets?  Five Defining Characteristics”, March 22, 2018, the balance on https://www.thebalance.com/what-are-emerging-markets-3305927  accessed on June 18, 2018.
[2] As measured by the return in the iShares Core Emerging Markets ETF (symbol: IEMG). 

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Is this about to change?

Up until this year, long-term US Treasury yields were the “toast of the town” for a long while.  Going back three decades, bond yields, for the most part, have declined (and prices have risen).  Bond yields touched new multi-decade lows even after the trough of the Great Recession in 2008.

Have bond investors enjoyed too much of a good thing?

Today, bond yields appear too low, even if inflation behaves.  If inflation were to rear its ugly head, then bonds could be “toast”.

Let us see why.

“Real” vs. “Nominal” Bond Yields

The chart above examines yields on US Treasury bonds maturing in 10 years – with a twist.

Traditional charts display prices in nominal terms.  For example, an investor buying a US Treasury Bond with the intent to hold it to maturity in 10 years, the investor would receive interest of around 3.1% per year.  (Of course, this does not take into account any fluctuations in price from market volatility.  This is why bond investors should focus on total return, price return plus yield, and not just yield.)

However, many bond investors also look at bonds in terms of real returns.  Real returns consider how the income an investor receives tomorrow is impacted by the prices that investor will pay to support his or her lifestyle (or fund someone else’s liability).  In other words, take the nominal yield and subtract annual inflation to calculate the bond yield in real terms.

The chart above shows yields on US Treasury bonds with maturities of 10 years in real terms.  (Sometimes, this presentation of bond yields is referred to as “real bond yields”.)   The rate of annual inflation is “core inflation” excluding food and energy.  This index is published monthly by the US Bureau of Labor Statistics.

Nominal yields have risen from roughly 2.5% last summer to 3.1%.  Yet, when we look at bond yields in real terms, the increase appears quite modest (and yields quite low), even compared to recent history.

Currently, real yields are at 0.6%.  In other words, investing in the 10-Year Treasury would yield an investor income growing 0.6% above inflation (assuming it stayed constant).  That seems low.

Only 7 years ago in 2010, investors could have earned real yields as high as 2.5% above inflation.  That was a time where the Fed was not hiking interest rates.  Markets worried about the duration and sustainability of economic growth.  (Even some questioned whether the US was really in as bad shape as Japan 2 decades ago.)

Today is a different story.  The Fed is entering its third year of tightening.  The economy is entering the second longest duration of recovery in recorded US history.  (Of course, the size of the recovery is also weak by historical standards.)  Inflation might also be ticking upward (and certainly not negative, which was the fear only 7 years ago).

What is the conclusion?   Real bond yields might potentially have room to move up, even if we just look at recent history.  Even if core inflation stays tame, simply the premium on nominal yields to inflation could simply rise toward 2.5% from current levels.  Keep in mind that the Fed has begun to shed some of the bonds it bought in earlier, multiple bond-buying sprees of Quantitative Easing less than a decade ago.

If inflation ticked upward, that could put additional pressure on long-duration bonds.

Bond investors might be in for interesting times ahead…

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The above chart suggests high yield corporate bonds are enjoying calm weather.

Data compiled by Cohanzick Management, a New York-based asset manager, and Bank America show the amount of US high yield corporate bonds[1] priced as if they were going to default in the near future.  The data include corporate bonds that trade 10% or more (1,000 basis points) above the yield of the equivalent US Treasury bond.  Such bonds appear to sport high yields, but they do so with a reason: fear that the company could choose not to pay bondholders back and default.  Think Toys R Us as one recent example of a company that eventually went bankrupt.

The blue bars represent the absolute level (market value) of bonds priced for bankruptcy for a given year.

The yellow line shows the percentage of the total high yield market that is priced as if it were going to default.

Whether an issuer priced as distressed actually defaults or not depends on the situation.  Often the market is correct about such dire prospects.  Sometimes, the market overly panics, and the company manages to find a way to bail itself out.  What matters for this discussion, though, is this: what message is the high yield market sending about the US economy overall?

Currently, the level of bonds priced for default is about 3% of the total US high yield market.  This is close to the lows set earlier this century.  While this number appears good for the moment, there are also reasons to be concerned.

Defaults at this level are likely to get worse, not better, based on past history. Two historical precedents for a bear case going forward might include:

1. 1999: TMT[2] on the eve of the dot-com bubble bursting, when the Fed also had just been hiking interest rates aggressively after pumping in excess liquidity to stave off contagion from the Russia debt default/emerging market crisis to the US. High yield defaults were concentrated mainly in those sectors, but the economy later turned into recession, and stocks corrected.
2. 2006: The housing bubble was about to burst. The Fed was raising interest rates while oil was over $100 a barrel.  It took another 2 years before we finally entered the Great Recession.  Numerous sectors experienced high defaults.  Stocks corrected.

A more benign case might consist of something like 2003.  Interest rates remained quite accommodative for a long time.  Steady economic growth and reasonable interest rates prolonged a benign credit cycle for years.  Eventually, however, it gave way to asset bubbles particularly in the housing and debt markets.

What lessons might we learn for today?

Economic recovery, while the second longest on record, has also been tepid, as evidenced by the weakest level of growth in recorded US history.  The hangover from the financial crisis has allowed central banks to keep interest rates low even after recent rises.  Additionally, low inflation has also resulted in robust profit margins for many companies.

However, any change in inflation might make central banks tighten short-term interest rates more aggressively.  Cost pressures from either wage or input price inflation might weaken corporate margins.  A combination of these two issues might put pressure on certain issuers in the high yield market.  That might send a warning signal to corporate credit and adversely impact other assets, including equities.

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[1] “A high-yield bond is a high paying bond with a lower credit rating than investment-grade corporate bonds, Treasury bonds, and municipal bonds.  Because of the higher risk of default, these bonds pay a higher yield than investment grade bonds.  Issuers of high-yield debt tend to be startup companies or capital-intensive firms with high debt ratios.”  Source: Investopedia, https://www.investopedia.com/terms/h/high_yield_bond.asp  accessed on May 17, 2018.
[2] “What is the ‘Technology, Media, and Telecom (TMT) Sector” on https://www.investopedia.com/terms/t/technology-media-and-communications-tmc-sector.asp  accessed on May 17, 2018.

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“The stock market has predicted 9 of the past 5 recessions.”  Paul Samuelson (Nobel Prize-winning economist in 1966 Newsweek article)

There is a better weathervane than stocks to forecast if the economy has hit the skids.

Please let us know of any questions.

Watch Treasury bond yields, not stocks, to know when to worry.

Yields on major bonds issued by the Treasury have done a pretty credible job of signaling economic recession in the last half-century.

The chart above displays the slope of the yield curve in the US Treasury bond market.  The “slope” is defined as the difference between the yield provided by Treasury bonds with a stated maturity of 10 years (“10 Year yields”) vs. the yield provided by bonds with a maturity of 2 years (“2 Year yields”).  This difference is also known as “spread”.

When the slope is positive, or greater than zero, that has typically indicated a growing economy.  When the slope goes to zero or turns negative, that has been a near perfect indicator that the economy is shrinking or slipping into recession.

The performance on your investments is directly related to the performance of the US economy.

• “Risk on” assets, that is, investments that benefit from economic growth, tend to rise in price over time when the economy is growing.  Stocks, high-yield corporate bonds, and many commodities are examples of “risk on” assets.
• “Risk off” assets, investments that attract investors in times of fear and uncertainty, tend to do better than “risk on” assets when economic growth turns negative.  Gold and Treasury bonds with long maturities are examples of “risk off” assets.

Since 1976, the slope of the yield curve has turned negative 4 times (1978-1982, 1989, 2000-1, 2007).  (Refer to the black arrows, including the large one marked “Great Recession”.)  Once the slope turned and stayed negative, “risk on” assets sold off and performed poorly relative to “risk off” assets.  In all 4 cases, the US economy soon fell into recession and posted negative growth.

The good news is that the slope of the yield curve has been mostly positive over the last 5 decades.  “Risk on” assets have benefited with positive returns for most of this time period.

But when the yield curve turns negative, all bets are off. 

What about today?  (Refer to the yellow arrow “We are here”.)

The yield curve currently has a modest positive slope of less than one half of one percent.  This reflects expectations for the US Federal Reserve to influence rates upward for bonds with shorter maturities.  Long-term yields are still greater than yields on bonds with shorter maturities, but the gap has reduced from a couple of years ago.  This reflects that market participants have some concern that the Fed runs the risk of raising interest rates too quickly and might potentially cause a future recession.

However, there might be a historical precedent of a narrowly positive yield curve persisting for some time: 1995-2000.  This was also a time of strong returns for “risk on” assets.  It eventually led to a brief bear market and recession to start the new century.  However, this took several years to play out.

We monitor the yield curve as one important indicator of where we are in the economic cycle.

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When you put together price appreciation with growth in corporate profits for different global markets, you get some interesting, even surprising, conclusions.

The table below sums the results.  A positive number (“Rerating”) means price appreciation has exceeded growth in corporate profits, perhaps suggesting that the market is now valued more expensively.  Conversely, a negative number (“Derating”) means price appreciation has lagged growth in corporate profits, implying the market is valued more cheaply than prior to 2008.

Note: ETF’s used to calculate total return from 12/31/2007 to 9/20/2018.  Total return includes price performance and dividends in US Dollar terms.

ETF’s used included EEM (Emerging Markets), EWJ (Japan), SPY (US), EZU (Europe ex-US), and EWU (United Kingdom).  These are suggested proxies for the underlying equity markets and not indicative on any recommendation.

Source: ycharts.com, MSCI, T. Rowe Price, iShares, and Ambassador Wealth estimates. 

USA Is Number One, But Will It Stay That Way?

The US has been the valedictorian over this decade when it comes to robust corporate earnings growth.

However, the US market has also experienced price appreciation far greater than growth in earnings.  Potentially, that might be a red flag for the market.  (However, we would argue that it reflects more on specific parts of the market, such as certain high-flying technology stocks, rather than necessarily a wholesale indictment of the US market overall.)

Japan Might Be Cheap If Corporate Profits Hold Up

Japan reflects moderate undervaluation relative to earnings.  As discussed earlier, Japan faces investor skepticism to the durability of its earnings recovery.  Yet, if and as earnings continue to grow, the market might have potential to rerate, or at least hold its own in the event global markets were to sell off.

Emerging Markets – Glass Half Empty or Full?

In spite of their poor performance over the last decade, Emerging Markets appear quite fairly-valued (not expensive, neither cheap) given where earnings stand.  A resumption in earnings growth could help the asset class.

Biggest Losers Are Europe With or Without the UK

Europe and the UK surprisingly look overvalued relative to earnings.  Indeed, on this measure, the UK is the most expensive market in the world based on markets outperforming the decline in corporate earnings.  This is even worse than the US.  Unlike the US, neither the UK nor Europe boasts large high-growth, high-valuation technology companies.  Europe and the UK are simply victims of poor earnings.

It would take a significant recovery in corporate profits just to work off the overvaluation in these markets to bring them back to fair value.  That does not rule out occasional fits and short-term rallies.  However, it appears difficult for Europe to post a meaningful bull market for the time being.

We also dare not neglect the macro risks surrounding Brexit and the Euro.  Europe might be swimming upstream for a while.

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What actually happened over the last decade?  Take a look.

Note: ETF’s used to calculate total return from 12/31/2007 to 9/20/2018. Total return includes price performance and dividends in US Dollar terms.
ETF’s used included EEM (Emerging Markets), EWJ (Japan), SPY (US), EZU (Europe ex-US), and EWU (United Kingdom). These are suggested proxies for the underlying equity markets and not indicative on any recommendation.
Source: ycharts.com, iShares, and Ambassador Wealth estimates. 

USA Dominates the World

What stands out is the performance of US stocks.  Over the last decade (including the bear market of 2008), US stocks have done well.  US stocks have yielded a cumulative return of nearly 150% over the last 10 years.  On an annualized basis, the US has returned roughly 9% per year.  Not only is that a decent return, but it places US stocks as the top region in the world over the last decade.

Some of the strong return performance of the US relative to ROW (“Rest of the World”) stems from superior corporate earnings performance.  However, as we shall see in the next section, corporate earnings do not explain the total picture.

Europe and Emerging Markets Have Been Dull

In contrast, international markets have been relative losers.  Emerging Markets, the UK, and Europe ex-UK have been practically flat over the last decade!

In the case of Europe and the UK, further declines in corporate earnings since 2008 have been a major culprit.  Lower earnings compel investors less excited about paying much for them.  Both Europe and the UK have heavy exposure to banks, which have seen dramatic earnings downgrades due to a host of issues, including low-interest rates and much stricter capital requirements following the Global Financial Crisis.  Other regulated industries such as utilities and telecom have also suffered huge earnings declines.  There are very few high-growth technology companies in European indices.  Hence, the European markets have performed quite badly this decade.

Emerging Markets is more of a mixed bag.  While performance has been similar to that of Europe and the UK, Emerging Market companies are sporting better earnings.  Earnings have been more volatile and below their historic highs.  Additionally, markets have questioned the quality of those earnings, given Chinese state-owned companies are a major part of Emerging Markets.  Macro concerns about the impact of higher US interest rates on Emerging Markets, trade wars, and rising political risks in major countries have also been more of an overhang for investors than the attractiveness of specific companies.

Could the Sun Keep Rising in Japan?

Japan is also an interesting case.  In spite of robust earnings that rival those of the US, returns have been only slightly better than its international peers.  Part of it stems from skepticism on earnings in light of significant demographic challenges in the country (aging population, mature economy) and how much monetary policy has inflated earnings.  On the flip side, Japanese companies have expanded their international operations, improved corporate governance, and funded higher dividends and share buybacks with cash, not debt like in the US.

Putting earnings and market performance together yields some interesting results.  Read the next installment for some surprising conclusions.

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Our asset allocation has favored the United States and Japan at the expense of Europe and Emerging Markets.  A long-term perspective on corporate profits and valuation might still justify this stance.  Let’s see how.

The Science and Art of Valuing Investments

How do you value an investment?  While there is a bit of “art” to defining that, we can still apply some “science” to get us closer to the answer.

One simple way is to look at the annual profit the investment is expected to produce.  Then figure out how much you are willing to pay for it.  Whether it be equities, real estate, or an oil well, you typically would expect to pay some multiple (several years equivalent) on that one year’s worth of profit.

If you look at this ratio as valuation divided by profit, you have what many call a “Price to Earnings” ratio.  There are other ways to describe this ratio (for instance, capitalization rates in real estate where you take the reciprocal, e.g. profit/cash flow divided by valuation paid, and expressed as a percentage).

For the purposes of this exercise, we will use the “Price to Earnings” approach.

Let’s look at profits prior to the last (and quite severe) bear market of 2008.

Earnings Recovery Strong in US and Japan, Weak in Europe, Tepid in Emerging Markets

The chart below shows earnings compiled by MSCI for 5 major regional stock markets around the world: Emerging Markets, Japan, the United States, Europe (Excluding the United Kingdom), and the UK.  The chart looks backward at what earnings were in the year 2008 (known as “the Global Financial Crisis”).  Each regional market’s earnings are indexed to the number “100”.

The chart then examines what happened to earnings every year up to 2018.  We particularly want to focus on the years 2008 and 2018 for this analysis.  2008 is the start of our analysis (arguably a “high” level of earnings prior to the bear market and economic recession).  2018 reflects where earnings are right now.

If a line for the year 2018 is above 100, that means earnings today for a given regional market are above their level back in the prior cyclical peak of 2008.  Companies in that market are making more money than a decade ago.

However, if a line in 2018 is below 100, that means earnings today are still below levels of 2008.

What can we learn about earnings in each of these major regions of the world?

Source: T. Rowe Price, MSCI, and Ambassador Wealth estimates.

Earnings are at historical highs in these markets:

• Japan
• United States

Earnings are better than 2008 now, but they are below prior historical peaks (and those of other strong markets):

• Emerging Markets

Earnings are below (indeed, substantially below) levels of 2008:

• Europe ex UK
• UK

In a future blog, we will discuss some of the reasons and potential future implications for the direction of earnings and valuations.

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Should investors be concerned when geopolitical headlines from overseas resurface?

News headlines about tensions between the US and North Korea might emerge again and give some investors caution after the recent rally in equities and other risk assets.   Past sell-offs in risk assets have bid up prices on perceived “safe haven” investments such as gold and US Treasuries.

We believe that investors ought not to panic over such news headlines, so long as economic fallout is limited.  If history is a guide, equities and gold potentially might hold their gains, while Treasuries could be at risk of a decline.

(1) Prior to 1972, gold was pegged to a fixed price in US Dollars. Hence, incidents prior to 1972 are excluded from this analysis.  The Bretton Woods accord in 1972 ended that arrangement.  (https://www.imf.org/external/about/histend.htm ) 

Source: http://www.multpl.com and Ambassador estimates.
Retrieved on November 15, 2017

We examined 20 major geopolitical events over the last 120 years that could have had significant impact on US financial markets.  (The data and findings below are sourced off the table above.)

Examples of major geopolitical events from the 20^th century include the onset of World War One in 1914, the attack on Pearl Harbor in 1941, the Cuban Missile Crisis of 1962, and the Arab Oil Embargo in 1973.  More recent examples in this current century include 9/11, war in Iraq and Afghanistan, the surprise Brexit vote, and several major terrorist attacks.

Equities

In the 12 months following such events, equity markets as measured by the S&P 500 Index gained roughly +4% (but with a wide disparity of outcomes ranging from +33% to -37%).  Equities achieved positive returns in roughly 2 out of 3 instances during these events of the 20^th and 21^st Centuries.

Gold

Gold, an investment favored by some investors in times of political uncertainty, often rallied a year after the event (average gain of +14% with a range of outcomes from +49% to -13%).  Since gold prices were deregulated in 1972, gold rallied over the next 12 months in 10 out of 13 instances (76% of the sample).

Bonds

In contrast, the 10-year US Treasury Bond, also considered a “safe haven” in times of uncertainty, tended to lose money the year after a geopolitical event.  These long-term Treasuries lost an average of -6% (with a range of outcomes from +45% to -62%) and posted declines in over half of the instances examined.

The times when equities suffered their worst losses a year later (such as the Arab Oil Embargo in 1973 and 9/11 in 2001) also coincided with the recession.  Gold and Treasuries posted gains following 9/11 but suffered losses in 1973 due to higher inflation.

These results might imply that investors ought to focus more on negative ramifications for the US economy as opposed to merely political impact from headline geopolitical events.

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As of market close on February 8, 2018, the S&P 500 has corrected more than any time in the last year.

Some of the reasons are fundamental (high valuations in most asset classes), but the extent of the recent sell-off appears more technically driven.

The drawdown in the S&P 500 from peak to trough prices in 2018 is approaching -10%, which already far exceeds the very modest drawdown of -3% in all of 2017 and breaks the streak of over a year without a -5% correction.  On the flip side, this recent correction is below the -20% drawdown in 2011 (when fears of Greece bringing down the Euro weighed on markets).

What is really upsetting the markets this week?  The bomb that some investors did not understand.

This is not a story of Exchange Traded Funds failing the market.  This is partially a story of certain investors speculating on the world becoming a calmer place (and getting it wrong).

Chart Showing Exchange Traded Note that Bets on Falling Volatility

Exchange Traded Products (ETP’s) have made it easier for retail investors to access alternative asset classes once limited to large institutional investors.  One such alternative asset classes is “volatility”.

Simplistically, “volatility” is taking a view on the turbulence (or calm) that major market indices should experience in the future.  Investors taking a constructive view of rising volatility anticipate a wider range of market changes, even if they do not know whether the change is positive or negative.  In other words, a positive view on volatility implies more response (fear or greed) in regards to the future.   (Though, as we have seen recently, higher volatility tends to occur more frequently with sharper market declines than advances.)

Conversely, investors taking a negative view on volatility believe markets are overreacting to future events in either direction (or a view of “Don’t worry, be happy”).  Such investors could ground their caution on volatility due to the fact that central banks will intervene in either direction if markets get too out of hand.

ETP’s exist both for bulls and bears on “volatility”.  Until recently, investors betting against volatility have made a killing on such investments.  That is, until February 2018.

Chart Showing Exchange Traded Note that Bets on Rising Volatility

Insurance companies and certain institutional investors trade volatility to hedge their books.  That would appear to be the contributor to the recent roller-coaster ride in markets.  (The huge spike in the blue line in the bottom chart above might reflect these technical factors, which in past years have ultimately dissipated.)

The magnitude of the correction is not outsized relative to corrections within bull markets.  The speed that it took place absent from major fundamental news suggests technical factors, like perhaps an unwind in negative volatility trades, are exacerbating it.

If this proves to be the case, there is potential for the market to stabilize absent adverse changes in fundamentals.  We remain cautiously optimistic.

(Full disclosure: Ambassador clients did not and do not have exposure to the ETP’s discussed in this blog.)

Chart Showing Exchange Traded Note that Bets on Rising Volatility

Some things to put into perspective:

1. US economy near-term shows no signs of recession.
• Yield curve is positive (though much less so than recent past).
  • Generally, when longer-term interest rates are greater than shorter-term interest rates, the US economy is expanding.
  • When shorter-term interest rates exceed longer-term rates, that has signaled a deterioration in US economic activity. (See the black arrows that show economic recessions.)
  • Markets correct in the face of economic recessions (and declines in corporate profits).
2. We were due for some selling following an unprecedented run in the market over the last year. As research house Strategas cites, strong years with low volatility might often presage higher volatility in the following year.  Drawdowns (defined as declines from market peak to trough) of -6% or more are common.  However, 6 of 9 such years still resulted in market gains for the year, albeit less dramatic than the year before.

   

3. Good economic news is a mixed bag for the markets.

   For example, the January jobs report showed decent jobs growth, lower unemployment, and an uptick in wages.  Market players got spooked that the Federal Reserve would hike rates further and risk slowing the economy too much.Recent strong market gains in January also have left valuations high, even though the strong economy generally has resulted in a positive 4q earnings report season.

   Recent history over the last 25 years suggests that while future market gains might slow, the level of interest rates themselves might not derail the market in and of themselves. The chart below shows that the yield on 2-Year Treasury Bills now exceeds the dividend yield on the S&P 500 for the first time in nearly a decade (post-2008, the Great Recession or Global Financial Crisis).

   However, taken over a longer timeframe, 2-Year Treasury yields have actually been much higher both in absolute terms and even relative to the dividend yield of the S&P 500.  Given what we know about the current environment, a further rise in the 2-Year Treasury from current levels of 2.1% to say 3.0% might not necessarily pressure that of the S&P (at least based on history from the economic expansions earlier in the mid-2000’s and mid-1990’s).

   The one signal we would be wary of is signs of economic recession (gray shaded areas in the graphs).  If history were to repeat, that might portend a market correction of greater magnitude.  For reasons that will be discussed in a future blog, we believe a recession is unlikely in the near term.

   

4. We remain cautiously optimistic on select risk assets in 2018. As we discussed in our 2018 Investment Outlook, economic fundamentals are constructive (not only in the US), but valuation is full to excessive in many areas.

Some market pundits are more bullish:

“A market surge is ahead.  If you’re holding cash, you’re going to feel pretty stupid.”  Ray Dalio[1]

“I recognize that we are currently showing signs of entering the melt-up phase of the bull market.” Jeremy Grantham[2]

“The game of economic miracles is in its early innings.  The world is getting better.”  Warren Buffett[3]

What we like:

• Cautiously optimistic on equities (still cheaper than fixed income)
• Broader exposure beyond S&P (Japan, small cap, small portion of emerging markets)
• Liquid absolute return strategies less correlated to equities or fixed income (call writing)

What we dislike:

• Much of fixed income (duration, most credit expensive)
• Europe
• Many illiquid “alternative” strategies

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[1] https://www.cnbc.com/2018/01/23/ray-dalio-says-market-surge-may-be-ahead-if-youre-holding-cash-youre-going-to-feel-pretty-stupid.html  accessed on February 2, 2018.
[2] https://www.bloomberg.com/news/articles/2018-01-03/gmo-s-grantham-says-stocks-could-be-heading-for-a-melt-up  accessed on February 2, 2018.
[3] https://www.bloomberg.com/news/articles/2018-01-04/warren-buffett-remains-optimistic-about-america-s-future   accessed on February 2, 2018.

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