Comparing the first half of 2017 with that of 2016, the improvement is remarkable. Between January 1, 2016 and June 30, U.S. equities had their worst correction in at least four years, only to regain footing and limp to the June 30, 2016 finish line with a 1% return, virtually all of it dividend income. By contrast, this year’s first half was among the best in over ten years for stocks, with a gain of about 9% for both the Standard & Poor’s 500 Index and the Dow Jones Industrial Average. The growth oriented NASDAQ composite jumped 14%, while fixed income holdings generated modest single digit gains. Long bonds were surprising in their price strength. The short end of the curve shifted up as the Federal Reserve raised interest rates in June for the second time this year, but investor appetite for Treasury bonds pushed the longer end of the curve down. The Fed also announced plans to reduce the size of its balance sheet–meaning it would stop reinvesting coupon payments and eventually begin selling bonds–but the market shrugged at the news. The yield on the 10-year T-bond finished the quarter at 2.31%, down 9 basis points from the end of March. This dynamic was especially helpful for fixed income holdings with long durations such as long-term bonds and preferred stock.…and while short term, overnight rates have been raised this year, long term rates are far more to the overall health of the economy. Mortgage rates have fallen just a bit in 2017, good news for the economically important housing market. It is not an exaggeration to call this a “Goldilocks” recovery, with nearly all liquid assets plus real estate on a solid upward price trend.
Good times in the United States are showing themselves overseas as well. For the first time in many years all major world stock markets are rising as the result of business expansion. In fact, the hottest markets last quarter were overseas, where both emerging and developed markets saw the best six months in at least four years. We were arguably behind the curve in that few client accounts held foreign based companies. Still, many holdings derive earnings from ample foreign sales, such as Johnson & Johnson, Microsoft, Apple, Mastercard and American Tower. You are likely to see some of your cash holdings deployed to this sector in the coming weeks.
The Economy
Some observers complain that the economy is not booming enough, but it is notable that initial claims for unemployment insurance have not been this low for decades, while “help wanted” signs proliferate. Others worry that this, the third longest recovery since World War II is bound to stumble, that stocks are overvalued, that wage inflation will drive overall inflation with interest rates following higher to snuff out growth. I think the naysayers are doing rear view mirror analysis. We truly are in a global economy where conventional, domestically oriented thinking is less useful.
For example, with nearly every past economic expansion, nine years in, the cost of money (interest rates that must be paid for home loans, car loans, and installment credit) would be rising, with demand for borrowing strong and lenders becoming too generous and giving money to poor credit borrowers. Not this time. Banks, recalling the run up to the last financial collapse, are generally careful in making loans. This year’s “Stress test” yielded reassuring results for nearly all systematically important U.S. banks. The Fed has been raising short term interest rates, but uncharacteristically this is not causing a parallel rise in long term borrowing rates. Why? US interest rates, low by our historical standards, remain the highest of any stable developed economy. Where do German pension funds, Japanese insurance companies and Brazilian politicians want to store their money? The USA. Strong demand for treasury and quality corporate bonds or mortgage bonds pressures interest rates lower. The Federal Reserve has announced plans to “normalize” its balance sheet, that is, sell off $billions in bonds it bought in the recession years when it was trying to offset the lack of confidence and to keep short term interest rates lower. The announced change in approach raises the fear among some that the Fed’s gradual exit as a bond buyer will push interest rates higher and snuff out the recovery. Consider that in August 2013, bond markets suffered a “taper tantrum” because then Fed President Ben Bernanke mentioned the desire to normalize functions of the central bank. Clearly, the atmosphere is more sanguine today. If the Federal Reserve is successful in bringing its balance sheet closer to historic norms, say over the next four years, their effort to rescue the economy will be the longest and most successful in the 100-year history of this institution. With luck, foreign central banks will trod the same happy path.
Inflation is surprisingly tame, and there are various attributions: a strong dollar keeps imports cheap, the ocean of shale oil and pipelines bringing it to the world market keep fuel prices down. Cheap feedstocks from abundant natural gas have lowered the price of ethylene, a major raw material to produce plastics. Look around you at how many things are made of or packaged in plastic. Technology continues to replace people in a wide variety of industries, especially retail. Tech “solutions” mean fewer good paying jobs for those with limited education and or needed skills. While this situation painful for many people, it is great for keeping wages and inflation tame. With Republicans in control of D.C., do not expect any Big Spending proposals to alleviate the low wage trap in which many are caught.
Then there is the psychological aspect of spending. First, Americans are notorious bargain hunters. The internet allows for constant price comparison. It is not unusual for a shopper, considering a pair of shoes in store to whip out her smart phone and check its price on Zappos. The greatest accumulation of consumer wealth is held by retired or soon-to-retire people. These are not your big spenders, out purchasing souped up trucks with $1,600 chrome-molly wheels. Then too, Millennials have, in general, not shown themselves to be voracious consumers. Some believe this is due to their first hand witnessing of hard times for their parents and perhaps themselves during the last recession, when unemployment rates were stuck at high levels for some 6 years. Like the example cited above, younger folks are tech savvy shoppers as well. Yet, the inevitable pull of their life cycle: marriage, children, home-with-a-back-yard, minivan in the garage, is and will be an important driver of consumer spending. Their spending behavior, though muted when compared to their parents, is, never-the-less likely to be key to a continuing economic recovery.
